Between 2010 and 2014, $1,400bn US commercial real estate loans will reach the end of their terms. Nearly half of them are currently in negative equity – that is, the borrower owes more than the property is worth. And banks are reducing the number of loans in the sector, and have been doing so throughout 2009.
More shocking is that banks and their auditors are typically well aware of the problem, but have not written down the value of property as prices have fallen. Instead they are “extending and pretending” – or “delaying and praying”: holding property values steady and assisting the borrowers where possible. They need to. If banks were accurately to record property values, they would write down assets on their own balance sheets and jeopardise their business (see example to right).
A very thorough report just released from the Congressional Oversight Panel expects many banks to go under when the pretence comes to an end. The report concludes: “There is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public.”
When a government body admits things are at crisis proportions, you have to take notice. This isn’t journalistic hyperbole. It is hard to overstate the impact of the coming second subprime, hitting, as it will, a very fragile economic recovery.
So, who will be most affected? In a nutshell, banks, and mostly the smaller ones. “Large loan losses and the failure of some small and regional banks appear to some experienced analysts to be inevitable,” says the report. But it is by no means only banks affected (see pie, right): 54 per cent of exposure sits throughout the financial system.
CRE financing – standing at about $3,400bn – splits into two parts: loans and commercial mortgage-backed securities (CMBS). Typically, smaller banks hold more loans and large banks hold the CMBS. In a reversal of the residential set-up, it is the lower risk loans that are securitised. 
Commercial real estate loans
Rising loan defaults on commercial property – to those of us who don’t own it – may seem distant. But the transmission mechanism to the man in the street is pretty direct: (1) Company closure & job losses; (2) Bank credit crunch, 2.0; (3) More bail-outs; (4) In the US, 26.5 per cent of CRE loans finance multi-family dwellings, so some people might lose their homes even if they have never missed a rent payment.
A soaring economy could forestall the problem, by raising property prices back to the level they are currently recorded on banks’ balance sheets. However, first, as the COP report says: “There is no way to predict with assurance whether an economic recovery of sufficient strength will occur to reduce these risks before the large-scale need for commercial mortgage refinancing that is expected to begin in 2011-2013″ (p137). And second, if I were a bank and a loss-making asset had just regained enough value to break even, I would sell as quickly as I could.
Commercial mortgage-backed securities
The $709bn outstanding CMBS should not be underestimated. Ownership is concentrated in large commercial banks. FDIC data shows that banks with assets greater than $10bn hold 94.5 per cent of total bank exposure to CMBS. The report observes grimly: “CMBS losses will potentially trigger capital consequences.”
There is a further problem with CMBS: the banks have far less ability to extend and pretend. With a bank loan, the bank can help the borrower – by reducing payments, say – thus keeping their own balance sheets intact. With securities, the market sets the price. So the market decides on the value of the bank’s balance sheet, and therefore on capital availability.
Delinquencies are rising, and full impact is scheduled some time next year. And the problem is by no means confined to the US. Evan Davies of the BBC made an excellent radio programme on this subject, full of facts and figures on the UK market. Recommended reading, and recommended listening.
And, for visual learners, an explanation of CMBS:
