Douglas French: Community, regional banks dominate real estate loans

“Commercial real estate is also dependent on finance, but it’s far less of a driver for the banks,” Susan Wachter opined in a recent edition of the Opelika-Auburn News.

While Ms. Wachter, a professor of real estate and finance at the University of Pennsylvania’s Wharton School, is right to be bearish on the prospects for commercial real estate, she is far too sanguine about the effects dud commercial real estate loans will have on the nation’s banks.

The Federal Reserve estimates that the commercial property market totals $6.5 trillion, with loans against these properties totaling $3.3 trillion, or roughly a third of the U.S. residential mortgage market. So on the surface, the commercial real estate loan market appears to be less a threat to bank balance sheets than residential mortgages. However, 60 percent of the nation’s commercial real estate loans are held by small community and regional banks.

These banks may only hold 28 percent of the banking industry’s total assets, but they make up over 98 percent of the nation’s 8,200 banks and savings institutions.

Professor Wachter, comfortably tucked away in her Ivory Tower in the shadow of the east coast money center banks, may not be all that concerned about a rash of garden office and strip-shopping center loans hitting the ditch.

However, for the vast majority of small banks who didn’t play the sub-prime mortgage game, but are hip deep in commercial construction loans, the plunging of commercial real estate values may spell the end of their existence.

Fifteen years ago less than two percent of U.S. banks and thrifts had exposure to commercial real estate that exceeded five times their Tier I capital, according to a report by Oxford Analytica.

But the recent real estate boom seduced most banks into property lending and by late 2008 that ratio had jumped to 12 percent.

With commercial property values down nearly 35 percent from the peak in October 2007, and the downturn just getting started, banks will be feeling the pain for months and years to come. Real estate consultant Foresight Analytics estimates that commercial property losses could reach $250 billion, causing another 700 banks to fail.

The downturn in property values is not due to overbuilding according to Professor Wachter, but is entirely due to the financial crisis.

That can’t be true with vacancies up and rental rates down, exacerbated by a rash of retailer bankruptcies like Circuit City, Levitz Furniture and Sharper Image.

Commercial developers saw the increase in housing as a signal to build more commercial properties to provide services to those new households.

It was the Federal Reserve’s low interest rate policies that provided false signals to the market, leaving homebuilders with homes they couldn’t sell and now commercial properties that aren’t needed. All might be well with the government assisted big Wall Street banks like Goldman Sachs, but the bottom is a long ways off for commercial real estate, threatening the solvency and stability of scores of regional and community banks.

Douglas E. French is President of the Ludwig von Mises Institute in Auburn.