Zoltan Szelyes

Commercial Real Estate, Banking Failures and Opportunities for New Money

CRE caused in many episodes in the past trouble for parts of the financial sector. CRE was to blame in Switzerland in the early nineties when several small banks had to be bailed out. While residential real estate prices for owner occupied properties increased sharply during the eighties, it was the collapse of the CRE market that brought down several institutions. CRE also took the center stage in the US at that time. The Resolution Trust Corporation (RTC) was set up to manage and liquidate real estate and financial assets that it inherited from insolvent thrift institutions. Between 1989 and 1995 747 thrifts with assets of around 400 bn. USD were liquidated. Commercial real estate was here the predominant issue. CRE and land loans played also a role in the Asian crisis. Real estate developers financed their land bank with foreign currency denominated loans. With the depreciation of the Asian currencies the debt could not be serviced and this had led to a wave of defaults.
The link between CRE and banking failures
In the light of the past experience it is somewhat surprising that this time it was the residential real estate market to trigger the financial crisis (I will address the US residential market in my next article: “Why this time residential real estate?”). However, the collapse of CRE values puts currently a heavy burden on banks’ balance sheets in the US and in some European countries. Problems with CRE and construction loans were last year the most important factor behind the collapse of more than one hundred financial institutions in the US. That’s why I would like to shed light on the important link between commercial real estate values and banking failures. In my view the commercial real estate credit is the credit class that can put the survival of financial institutions at some points in time most at risk when its addressed improperly from a risk management point of view. This is due to the following points:
➢ Strong pro-cyclicality of CRE
➢ Attractiveness of CRE loans during the boom leads to negligence of risk management
➢ Effect of the default of large undiversified positions on banks’ balance sheets
Strong pro-cyclicality of commercial real estate or why is commercial real estate prone to bubbles
Asset managers, insurance companies and pension funds usually own commercial real estate due its relatively stable and high income yields. This long term passive hold strategy is in my view however not the value maximizing approach to commercial real estate investments and can even be a very value destroying strategy at some points in time. Commercial real estate has very pro-cyclical total returns and has to be actively managed (cyclical timing necessary). A strong decline of CRE values can also come without an economic depression. CRE prices usually fall in normal downturns by 20-40%. The volatility of commercial real estate is the result of two factors: Volatility of incomes and the effect from leverage. Income volatility is the consequence of economic volatility. Vacancy rates and rental incomes vary during the economic cycle. If you own undiversified real estate portfolios the income backdrop in your portfolio during a recession can be much more pronounced as for the market as whole. Volatility of commercial real estate values also arises from the leverage applied to investments. Commercial real estate transactions involve usually debt financing. This increases potential returns and risks for investors. Not being able to service the debt can lead to default and the loss of the full equity contribution to such investments. If you have bad luck you need to liquidate parts of the portfolio in very illiquid environments. The effect from this leverage can create a much higher volatility for this asset class than seen on paper… Commercial real estate is also prone to bubbles. Bubbles can be seen as the result of illusions combined with leverage. Commercial real estate can provide in a benign economic environment income and rent growth illusions to investors. As investors become more and more optimistic they increase their debt loads, as they can leverage returns this way. The physical nature and the local presence of CRE can also give a false comfort to investors that there simply must be a value in such objects/projects. E.g. when assessing business plans of investments or construction projects and they see how great the building will look like they can fall into what I call “value illusion”. So the rational decision is biased by (emotional) affection. The other point is the usual high size of commercial real estate transactions. In the US the average sales price for commercial real estate deals is 25 mm$. This relative higher size of transactions makes CRE an attractive field for leveraged investors, especially when the cost of credit is low. That could not just be seen in the US and Europe during the boom years but actually currently in China with the government leverage leading to high inflows into commercial real estate. If you are following the commercial property market in Shanghai some trends there resemble to what has happened in the US in 2005/2006 The high size of the transactions combined with an explosive mixture of overly optimistic expectations and leverage can continue to inflate the CRE bubble as long as there is no trigger event to burst the bubble.
CRE loans as an attractive source of earnings during booms
CRE is linked to the banking system by means of commercial real estate mortgages, construction or mezzanine loans. Banks provide trough these instruments leverage to investors in CRE transactions.In a benign economic environment these instruments are an attractive source of earnings for lenders. Due to the large size of transactions the spread between financing costs and interest earned can lead to attractive income jumps for the lenders. A 100 million commercial real estate loan with 100 basis points margin for the bank generates net income of one million USD. Especially for smaller banks commercial real estate loans can increase the earnings and the manager can earn easily big bonuses. Disciplined credit risk management that relies on the principles of the MACRO REAL ESTATE Analysis Approach is here crucial, as all these earnings are at the expense of risks in the future. Lenders have to be aware of the risks if a loan defaults at a future date. As seen in the current crisis in a case of default the loss for the bank for the same 100 mm$ loan could be as high as 60 mn$. (I assumed a loss severity of 60%) For subordinate or mezzanine loans it can also be easily become a full loss. The best risk tools for lenders are here the loan to value ratios (LTV), the debt service coverage ratios and personal guarantees of the borrowers. However there is a tradeoff for the lender. With a higher LTV a higher income can be earned on a deal. But with higher LTVs also the risks rise in the case the borrower defaults. However, in a bullish competitive environment usually the credit risk department loses out in arguments against the dealmakers and LTVs rise and loans are approved at higher risks. That happened also during the boom in the US and risks for the banking system from commercial real estate increased on the whole.
Effect of the default of large undiversified positions on banks’ balance sheets
A sharp decline of CRE values together with a high LTV basis on its loans can threaten the existence of bank involved in CRE financing. Two further conditions needs to hold further for such a worst-case scenario to come true. First, the exposure of lenders to such loans has to be material relative to the capital and the equity position of the bank. This brings smaller banks at risk that granted relatively large loans, as per definition here a loan has a higher share of the bank’s balance sheet. But the same logic also applies to large players, who were aggressive lending at the late stage of the bubble. Late bubble vintage loans don’t have the time to accumulate enough equity and have usually higher LTVs and inflated appraisals. Second, there must be an immediate risk of a default of the loan to create a loss or an impairment charge. Accounting practices play in this aspect a key role. Loans are usually hold to maturity assets and don’t have to be marked to market. So commercial real estate loans are usually accounted at 100% in the balance sheet. Banks only have to account for loan losses if there is the risk of an immediate default. So theoretically the current mark to market LTV for such loans can be even 150% or higher, but the bank does not have to account for a loss if it believes that values rebound till maturity or no default event occurs. There are several events of default. A term default occurs when the borrower defaults on its interest payments or LTV or DSCR trigger events are broken. Maturity defaults occur when the borrower cannot repay the loan at maturity. So such default events are a necessary condition to affect banks’ balance sheet. And maturity matters, as it is an important trigger event for defaults and losses. If several loans on the balance sheet of a bank are maturing at the trough in a CRE price cycle this leads to large impairments or losses. And due to only few but large positions the losses don’t increase gradually but by leaps and bounds. This size effect is an important point that makes CRE financing for banks so risky. Compare a loss of one 100 mm$ CRE mortgage with 100 1 mm$ residential mortgages with identical loan criteria. The residential mortgage have to be perfectly correlated in any respect like credit score, maturity, inflation of the appraisal to create the same loss as the CRE loan.
Survival Strategies of Banks can lead to a restrictive credit stance
In an extreme case losses from CRE, construction or mezzanine loans can even threaten the survival of the bank in question. The only direct remedies- without a government bailout- that such a bank can follow are the extension of these loans or raising new equity. But also even after having secured its survival such a bank is still haunted by its actions in the past. Such banks are usually reluctant to engage into new business, as they try to earn their way out of insolvency. This can lead to a credit crunch not only for CRE loans but all sorts of loans as the bank tries to shrink and to deleverage its balance sheet.
Opportunities for new money in the current environment
While it is currently a very burdensome situation for the banks dealing with these balance sheet problems, a lot of opportunities arise for new money flowing into the sector. This new money has several opportunities from engaging into new lending, buying distressed debt to investing into commercial real estate properties. New money that targets lending can benefit from the current favorable environment:
➢ Risks for new lending have shrunk considerably due to the strong value decline and can be addressed by applying LTVs or DSCR.
➢ High negotiating power of lenders providing financing in the current environment
➢ Positive Selection borrowers which are still in the business, as bad borrowers have defaulted or will default and are losing their equity
➢ Free Field: The competition in lending decreased due to the paralysis of parts of the banking system. This leads to higher margins and lower competition
➢ Distressed Opportunities: Buying loans or properties from distressed sellers
However, there are no free lunches. A wrong operational implementation can lead also for sharp losses for new money flowing into the sector. A proper research based lending approach with extensive due diligence work and a strict credit risk control is a key for success.

Tags: Banking failure, Commercial Real Estate, property