Fed Ratchets Up Warnings on Commercial Real Estate Debt

CRE Under Pressure Due to Sharp Erosion in Fundamentals, Grubb & Ellis Economist Bach Less Bearish on Sector Outlook

Two officials from the U.S. Federal Reserve issued strong signals this week that the central bank is very concerned over the banking industry's exposure to commercial real estate loans and considers it to be a major stumbling block to the road to economic recovery.

In a speech Monday assessing the state of the U.S. economic recovery, Federal Reserve Bank of New York President and CEO William Dudley said he expects that "more pain lies ahead" for the commercial real estate sector and for banks with heavy exposure to CRE loans.

"The commercial real estate sector is under particular pressure because the fundamentals of the sector have deteriorated sharply and because the sector is highly dependent upon bank lending," Dudley said in the speech at the Fordham Corporate Law Center in New York.

Unemployment remains much too high and "it seems the recovery will be less robust than desired," with "significant excess slack" in the economy, Dudley said. Also, in something of a departure from recent Fed pronouncements, Dudley said the economy faces "meaningful downside risks to inflation over the next year or two."

Additionally, on Wednesday, The Wall Street Journal reported that a Fed official told banking industry regulators in a Sept. 29 presentation that "banks will be slow to recognize the severity of the loss" from commercial real estate loans, "just as they were in residential."

The presentation by K.C. Conroy, an Atlanta Fed official who is reportedly part of the central bank's "rapid response" program to spread information about looming economic problem areas to federal and state bank examiners, indicated that slumping property values and rising vacancy rates have exceeded those seen in the early 1990s recession and CRE losses would reach about 45% next year. Further, a WSJ analysis of regulatory filings found that banks with heavy exposure to CRE loans set aside just 38 cents in reserves during the second quarter for every $1 in bad loans -- a sharp decline from $1.58 in reserves for every $1 in bad loans from the beginning of 2007.

Grubb & Ellis Chief Economist Robert Bach told CoStar that, although he's far from optimistic about the market, he doesn't share the Fed's high level of pessimism, either.

"One reason I'm not as pessimistic is that I don't think that it's comparable to the residential crisis," Bach said. "Banks will have to declare more losses, but is it the type of crisis that will re-threaten the global financial architecture? I don't think so."

Bach notes that about $3.4 trillion in commercial mortgage loans are outstanding -- about one-third of the $10-$11 trillion in outstanding residential mortgages. A lot of the CRE loans losses will be concentrated in regional banks, and the FDIC has a time-tested procedure for shutting down, stabilizing and reopening such institutions with "a minimum of drama."

When the residential and subprime asset-backed securities market crumbled more than two years ago, the collapse threatened the major "too big to fail" institutions and caught everyone by surprise, sending the Treasury, the Fed and the world's other central banks scrambling for a plan to deal with the emergency, Bach said.

"Now, we know what to do. It's not going to be pleasant, it will be slogging through more losses" for two or three more years, he said.

In his remarks Monday, Dudley noted that financial markets are performing better and the economy is now recovering, if not at the rate regulators would like. He cited three forces restraining the pace of the recovery. Household net worth hasn't yet recovered from the housing price decline. Second, the fiscal stimulus that is currently providing support to economic activity is temporary rather than permanent and will abate over the next year.

Third, and perhaps most importantly, bank credit losses lag the business cycle and are still climbing, and the banking system has still not fully recovered. While banks’ access to the capital markets has sharply improved, institutions are still capital constrained and hesitant to expand their lending. Most significantly, significant classes of borrowers -- namely commercial real estate and small business -- are almost wholly dependent on the banking sector for funds that are not easily forthcoming, Dudley said.

Dudley said two main problems plague CRE fundamentals. First, capitalization rates had climbed sharply during the boom. At the peak, cap rates for prime properties were in the range of 5%. Today, the average cap rate appears to have risen to about 8%. Second, income generated by commercial property has generally been falling, Dudley noted. As the recession has pushed up the jobless rate, office demand has declined, and as the recession has led to a reduction in discretionary travel, hotel occupancy rates and room prices have declined. Retail sales have weakened, reducing demand for prime retail property.

Dudley said the decline in valuations has created a significant amount of rollover risk when loans and mortgages mature and need to be refinanced. The slump in valuations pushes up loan-to-value ratios, making lenders wary about extending new credit -- even in the case when these loans are performing on a cash-flow basis, the New York Fed president noted.