As the US banking sector prepares to report second-quarter earnings, focus will once again be on institutions’ commercial real estate exposure, and in particular the performance of their outstanding loans.
The problem is that much of the data may well not be reflecting the reality, or at least not the most worrying part of that reality. The latest clue – if fears about the long-term sustainability of areas such as office property were not enough – comes from the fact that reports are growing of banks looking to sell performing loans at a loss.
In banks’ first-quarter earnings numbers, CRE loan-loss allowances and the rates of nonaccrual and past-due loans were indeed rising, but they were still low. Nonaccruals were typically below 1%, certainly not rates that should cause a problem for sizeable regional banks.
Suddenly, a performing loan against an income-producing property has become a horror show for a lending bank
But these rates, while not meaningless, miss two of the bigger points for banks.
The first is that the CRE sector has a tendency to be binary. A loan can be performing fine, but if the property is abruptly vacated – either because a lease could not be renewed or because a tenant has failed – there is a sudden problem.
Second, and more importantly, loan-performance data often doesn’t say much about the likely underlying value of the property asset itself.
And that is the real killer.
That there is uncertainty around property values is unsurprising considering that big sales of commercial real estate are rare. When they do come, they provide a single data point through which the whole market is then reassessed.
Values falling
This year, each month that passes is adding more scattered reports of properties being sold at much lower prices than their previous values.
That is a problem for property sellers, of course, who have to book a loss. But the fact that they are still willing to sell at depressed prices shows their capitulation – that they feel it is better to cut their losses now rather than hang on to a property on which they will struggle to get a sufficient yield.
Assuming those sellers have enough equity to cover those losses, or most of those losses, then this shouldn’t particularly hit lenders.
But if the sellers can’t or won’t absorb those losses, they can walk away from the property. Suddenly, a performing loan against an income-producing property has become a horror show for a lending bank, which finds itself holding the keys to a demonstrably unattractive asset.
Any sales that are taking place will be providing ugly data to lenders that find themselves appraising properties they are being forced to take on.
The issue, then, is not that loans to property owners are getting dramatically worse in terms of performance – it is rather that there are more signs of property values falling. As in previous real estate-related crises, that isn’t necessarily a problem until the very moment that it is. And then, when banks are deluged with failed properties, they will take the hit.
This is why banks are not waiting for loans to stop performing and why they are increasingly willing to consider selling out. Performance data may well be worse in banks’ second-quarter figures, but the story certainly doesn’t end there.
