Fortune telling, though a terrific ice breaker at cocktail parties, is not the most practical process amongst economists and Wall Street Analysts (albeit a sometimes common trait). Conditions change rendering old conclusions inadequate, while offering limited ability to gain future insights. We don’t have a crystal ball to delve into the future, but this paper does the next best thing in connecting the dots and uncovering the factors to consider when determining the impact of commercial real estate loan default. We hope that the reader analyzing these factors as they fluctuate will find this paper to be a more useful tool than solely reading static conclusions. Currently, these factors and the conclusions that stem from them, indicate the potential for a negative effect on both the economy and hence, the stock market.
FACTORS WHICH AFFECT THE SCALE AND BREADTH OF CRE DEFAULTS
Despite the smaller market size of commercial real estate (CRE) loans, the volume of CRE loan default is expected to be comparable to that of residential loans.
While the commercial real estate (CRE) loan market is one third the size of the residential loan market with regards to the dollar amount of loans, ($3.38 trillion dollars versus $10.79 trillion) a greater portion of CRE loans are likely to be in default, leading to a potential downward pressure on the economy.
Despite its smaller market size, the dollar volume of commercial real estate loan delinquencies are expected in the next few years to rise to the level of residential loan delinquencies. Two trillion dollars (30%) of securitized residential loans (RMBS) are delinquent as of February 2010. This figure underestimates total residential loan delinquency as it does not include residential whole loans. RMBS constitute 62.5% of all residential loans. Currently, a significantly lower dollar volume of commercial loans are in default at $165.5 billion (4.9%), with $47 billion of securitized commercial loans (CMBS). CRE defaults are expected to rise to similar levels of residential defaults to $1.4 trillion from 2010 to 2013. (See Graph 1). An additional wave of CRE delinquencies is anticipated during 2015-2017 driven by CMBS loans due to their longer maturity dates, leading to $2.4 trillion delinquencies by 2018. The volume of CRE loan delinquencies would thus surpass current levels of securitized residential loan defaults.
Shorter loan maturities, inability to refinance, rate resets, and weak economy are several of the major factors which affect the scale and breadth of CRE loan defaults.
The scale of potential CRE loan losses could approach that of the residential loan losses despite its smaller market size, simply because CRE losses affect a wider group of borrowers than residential loans. Even “healthy borrowers” could face losses as the primary driver of default is term risk not just credit risk. Term risk includes “healthy borrowers” who are able to service their debt during the length of the loans, but may be unable to pay off the final payment. Unlike residential loans, which have 15 to 30 year maturities, loans on existing commercial properties have shorter durations with 3 to 10 years and a final balloon payment at the end of the term. As a result, CRE loans generally require refinancing to be paid off. Residential borrowers, who meet their monthly debt service, do not have the obligation to refinance. They could pay off the loans completely at maturity. Commercial borrowers, facing shorter loan maturities and balloon payments, must refinance in order to avoid default.
- 2010-2013 has the largest volume of total commercial mortgages maturities.
- 2015-2017 has the largest volume of CMBS maturities
Graph 1: Commercial Mortgage Maturities by Lender Type.
The ability of borrowers to refinance their maturing CRE loans is currently unlikely. The inability to refinance, due to fall in property values and tighter underwriting standards, causes a wider group (including “healthy borrowers”) to default. Similar to residential real estate, CRE values have dropped about 40% from their peak leaving nearly half of the borrowers with negative equity. The prior largest price drop was in the 1980s when prices fell 30-50% within 2 years resulting in the Savings and Loan Crisis. Even if the property values did not decline, healthy borrowers are faced with increasingly tighter underwriting standards as banks are reluctant to lend. These more restrictive standards include lower loan-to-value ratios which declined from 80-85% to 60-65% for first mortgages. Borrowers will face financial hardship in coming up with out-of-pocket capital to pay off their existing mortgages. Nearly two thirds of securitized and nearly 80% of 2007 vintage CRE loans have this “equity gap.” A total equity gap for CRE loans is estimated at over $1 trillion. Improvements in the economy, which lower vacancy rates and increase rents, will not materially alleviate the equity gap issue faced by the majority of CRE loans. Delinquencies due to the inability to refinance maturing loans constitute 3.0 % of loans from June to December 2009 by UPB and 7.9% by loan count according to Standard and Poor’s. We expect a further increase in delinquencies at maturity if the equity gap and tighter underwriting standards continue.
Similar to residential loans, commercial real estate loans also have a risk of default prior to maturity from missed payments—credit risk. Missed payments result from interest rate resets and weak economic conditions. Interest rate resets significantly led to the recent onslaught of residential loan defaults. Increased monthly payments from low teaser rates caused the default of many subprime mortgages. Diminishing incomes due to job losses from a weakened economy undermined the ability of already financially stretched borrowers to meet their loan payments, incurring another slew of defaults long after the reset dates of 2008 for the 2005 vintage residential loans. Delinquencies for the residential loans have continued to steadily escalate reaching their highest rates at 10.14% by the 4q of 2009.
Rate resets and weaker economic conditions have already started affecting CRE loans. Rate resets for CRE loans cause an increase of debt service by 20-25% for $100 billion CMBS loans through mid 2012. Loans with resets have nearly double the delinquency rates of other CMBS loans.
Weak economic conditions further elevate the level of delinquencies based on missed payments. Weak economic conditions lead companies who are tenants of commercial properties to default on their leases, ultimately diminishing property income used to cover the mortgage payments. So far the low interest rate on floating rate loans have helped compensate for the fall in income in order to service the debt. Recent data indicate missed monthly payments constituted a greater portion of delinquencies than those from the defaulting of maturing loans. Standard and Poor’s indicated missed payment resulted in 41.6% of troubled loans by loan count and 24% by unpaid balance from July to December 2009. As economic conditions deteriorate and/or interests rate resets we expect a further rise in delinquencies prior to loan maturities.
While the commercial real estate loan market is smaller than the residential loan market, the dollar losses have the potential to rise to the level of residential loan losses, primarily driven by term risk. The factors that lead to term risk default such as shorter maturities and inability to refinance due to the “equity gap” increase the breadth as well as the scale of CRE defaults. Rate resets and weak economic conditions lead to increasing volumes of defaulting CRE loans prior to maturity. Currently, a greater portion of delinquencies are due to missed payments. However, defaults of maturing loans have the potential to surpass credit risk related defaults over the next couple of years as they affect a much wider group of borrowers.
FACTORS WHICH CAUSE CRE LOAN DEFAULTS TO IMPACT FINANCIAL INSTITUTIONS
CRE loan losses are poised to damage financial institutions and weaken the U.S. economy.
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 Commercial Real Estate Losses and the Risk of Financial Stability, Congressional Oversight Panel, February 10, 2010, p. 16 citing C. Alan Garner, Is Commercial Real Estate Reliving the 1980s and Early 1990s?, Federal Reserve Bank of Kansas City – Economic Review, Fall 2008 p 91 (Fall 2008) (online at www.frbkc.org/Publicat/ECONREV/PDF/3q08Garner.pdf).
 Senior Loan Office Opinion Survey of Bank Lending Practices, Board of Governors of the Federal Reserve System, Feb 1, 2010 p. 3. www.federalreserve.gov/boarddocs/surveys
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