Harvard Business Review - U.S. Commercial Real Estate Is Headed Toward a Crisis

 

Interesting article from the Havard Business Review

I’ll include some excerpts from the article as it’s rather lengthy. The original link can be found here.

Harvard Business Review CRE Article

“Over the next two years, more $1 Trillion in CRE loans will come due”.

The damage could metastasize into a full blown financial cris if small and midsize banks fail simultaneously.

As the Federal Reserve keeps interest rates elevated and CRE risk worsen with falling property values, businesses will continue to experience restrictive financial conditions. Executives can nonetheless take steps to potentially mitigate the fallout – including examining banking relationships, extending debt maturities, and securing adequate working capital.

HOW DID WE GET HERE?

The risks of US Commercial banks being overexposed to CRE have intensive as the global pandemic upended long held economic assumptions: perpetually subdued inflation, low interest rates and in office work.

Exacerbating the situation are CRE management costs – including insurance premiums, labor, and energy prices.

THERE’S TROUBLE BREWING

Hundreds of banks hold an outsized amount of CRE loans on their books relative to capital. Small banks and midsize banks have CRE loan values far exceeding risk based capital levels at 158% and 228%, respectively. According to the Conference Board calculations using FDIC Institutional Financial Reports data. This is compared to 142% for large banks and 56% for the largest banks.

[I’ve cut and pasted the following provisions as the depth of data is frankly more than I want to try and summarize]

As CRE property values fall and the debt service on associated loans accumulates, borrowers are becoming delinquent or defaulting. The portion of these loans that are nonperforming more than doubled — from 0.54% to 1.25% — over the six quarters from the Q3 2022 cycle low, according to data compiled from BankRegData.com and the FDIC. Compare this with the just 0.87% rate six quarters after the cycle low, in the second quarter of 2006, which preceded the 2008–09 Great Recession. However, only the largest banks are reporting increases in nonperforming loans and charge-offs (i.e., losses). Reported CRE loan delinquencies exceeding 90 days have surged from under 1% in mid-2022 to 3% in early 2024 for the largest banks, while delinquency reports for all other banks remain near 1%, according to The Conference Board calculations using FDIC Institutional Financial Reports data. (By comparison, delinquency rates reached 5% in 2010 in the wake of the 2008–09 Great Recession.)

Meanwhile, CRE loan losses for the largest banks spiked to 0.6% in early 2024, while other banks are reporting virtually zero losses. By comparison, such losses topped 1.4% in 2010.

The reason for the different behaviors is that the biggest banks face greater regulatory scrutiny and are required to maintain larger capital cushions, prompting swifter realization and write-offs of souring loans. Smaller and midsize financial institutions — many of them regional and community banks — are evidently not marking down CRE loan losses but may be managing stresses differently.

These institutions are likely engaging in “extend and pretend” behaviors that lengthen loan maturities with the hope that property valuations will recover in the future. They also may be seeking to widen capital buffers through M&As with similarly sized or larger financial institutions.

WHAT COULD TRIGGER A CRE CRISIS

Multiple troubled banks simultaneously raising equity capital would prove challenging and potentially destabilizing for the U.S. banking system. Any hint of doing so could cause massive depositor flight (i.e., bank runs), creating a redux of the March 2023 panic across global financial markets when only three U.S. banks came under pressure. Digital banking has accelerated the speed at which these runs might occur.

The clock is ticking for banks delaying recognition of CRE loan losses, and the timing of the financial market fallout — potentially starting later this year — could be during a vulnerable period for the economy. The Conference Board expects that U.S. real GDP growth may be weaker, the unemployment rate slightly higher, and interest rates still near multi-decade peaks, when a cascade of banks begin reporting losses.

Other CRE crisis triggers could include a U.S. recession; interest rates that stay higher longer than expected; and/or financial market upheaval from a fiscal crisis (e.g., the looming January 2025 debt ceiling) prompting investors to demand greater credit risk compensation in the form of higher yields.

THE POTENTIAL FALLOUT

As these loan losses begin to mount, an increasing number of banks — mostly regional and community banks — risk having insufficient capital cushions. A 10% loss on CRE loans would leave more than 100 mostly small and midsize banks, representing nearly $700 billion in assets, undercapitalized. A 20% loss would render over 900 banks undercapitalized, including some larger banks.

 THE DEPTH BREADETH AND DURATION OF A CRISIS

Pandemic accelerated troubles in CRE markets may take more than a decade to resolve. The sharp rise in interest rates has caused commercial subtypes to lose value. Commercial properties prices have already fallen 21% from their mid-2022 peak according to Green Street.

HARDENING COMPANIES FOR A CRE STORM

Corporations should prepare for an extended period of tight lending, elevated borrowing costs, and possible market liquidity shortages. Prudent corporate managers should extend their debt maturities and add a cash liquidity buffer – now.

Corporate managers should know of any provisions allowing their financial institutions to transfer depositors’ assets to third parties for management. In such cases, executives should be aware of the safeguards their banks have I place should third party asset managers come under duress.

WEITZ TAKE: 

It's so refreshing to find an article like this.... I can't confirm their data is correct, but the context is right on. It's hard to say how long the 'can will be kicked down the road', but I struggle to see a cure for this without significant bank losses and upending of many parts of the commercial market. 

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Weitz Commercial

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