Charting Banking V: commercial real estate

by PlanMaestro

Most people have seen a similar version of this chart with a mountain of commercial real estate problems for banks:

But the fact is that for closed banks the percentage of CRE loans non accruing is much lower than C&D

So it looks like CRE issues have been much exaggerated compared to C&D’s. Part of its better performance up to now is because

  • Tighter Underwriting: no zero percent down loans or covenant lite
  • Better Collateral: most of it was leverage of already performing properties
  • Localized: the effects of the bubble was concentrated in specific sectors like retail
  • More Capital: small banks absorbed relatively a larger percentage of these loans while having better capital ratios

But there are also some particular characteristics of CRE loans that make them a better risk

  • statistics include owner occupied CRE loans that are much lower risk
  • has longer durations, spreading problem loans over several years
  • refinancing has a much higher probability of succeeding given that the collateral generates cash
  • several of the most problematic CRE loans at the top of the bubble were securitized  and sold like MPG’s Orange County acquisition

Some people call this “extend and pretend” and would agree when the cash flow is not present or the collateral is weak. But refinancing was and is an essential part of banking and this was not a CRE construction bubble like the end of the 80s. And for investors this “extend and pretend” has the advantage that progress is more gradual and the underwriting can be evaluated without sudden NPA collapses like could happen with C&D loans.

Concluding, for investors a large percentage of CRE loans is a risk but this risk is much easier to bound than C&D’s. Look for:

  • High percentage of owner occupied
  • Stabilizing CRE non performing assets, provisions and charge off trends. At this stage of the cycle should indicate good underwriting
  • Small concentration of loans in sectors with excesses like for example retail and hotels
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