Commercial real estate doesn't pose the same systemic risk as residential real estate.
Over the next five years, banks are exposed to roughly $350 billion dollars in underwater loans.
Last year, banks demonstrated their ability to absorb losses on a scale in line with future loss projections.
As economic recovery continues to gain momentum in the US, pessimism over potential obstacles remains high (which is actually a normal feature in bull markets). One particular area that's been an ongoing concern is the threat of continuing declines in the commercial real estate market. We'll break down the numbers—the total commercial real estate picture, what's at stake, what percent banks are on the hook for, and even worst-case scenario losses in the years ahead—and still show this doesn't have the capacity to cripple the banking industry (and threaten economic recovery) as so many fear.
At $3.4 trillion (including $900 million in outstanding multi-family loans outstanding), the total commercial real estate (CRE) market is a lightweight next to its residential counterpart, valued at close to $11 trillion. Simply put, given this broad scope discrepancy, CRE doesn't pose the same systemic risk as residential real estate. Between 2010 and 2014, $1.4 trillion in CRE loans are expected to mature—40% of the total market. Banks are exposed to roughly 50% of those maturing loans, or $700 billion, with half of that amount ($350 billion) mired in underwater loans.
To evaluate the expected bank losses tied to this exposure, we have to make a few assumptions. Realistically, mortgages only move into foreclosure if they're underwater—otherwise, the borrower could sell the property, pay off the loans, and pocket the difference. So this gets us our $350 billion starting figure. Given a price drop on CRE of 40% from the October 2007 peak, we will assume a sufficiently extreme 40% loss rate (the difference between the property value and loan amount). For example's sake, we will also assume a comparably extreme default rate of 100%. With these assumptions applied, banks would lose approximately $140 billion over the five-year period, or $7 billion per quarter on average.
While that may sound staggering—whether it's $7 billion, $19 billion (the government's "worst-case" quarterly loss projection), or anywhere in between—these losses shouldn't be debilitating. Last year, banks demonstrated their ability to absorb losses on this scale—CRE write downs hit $10 billion in Q2 2009, $11 billion in Q3 2009 and $13 billion in Q4 2009—and banks, in general, were still profitable. Additionally, small banks with less than $10 billion in assets have about three times the exposure as a percent of capital than large banks—translation: Little systemic risk. Additionally, banks are well capitalized to handle the CRE losses they do face, with an aggregated $120 billion more in loan loss reserves than two years ago, and 10% fewer loans outstanding.
There will be losses, and more banks will fail—but the industry is largely back on its feet and has demonstrated resilience in recent quarters. (And as we've written before, bank failures should be expected—they are normal after every financial crisis—and shouldn't derail overall economic or market recovery.) Investors can take confidence this recovery won't be knocked out by this much-heralded hurdle—CRE losses just don't pack as big a punch as feared.