In a note released earlier, Congressmen Paul Kanjorski and Ken Calvert stated that they are launching an "Effort Urging Federal Regulators to Address Growing Commercial Real Estate Market Concerns" which will focus on the economic implications of the "deteriorating conditions in the commercial real estate." Luckily, Kanjorski bypasses the spin cycle and calls the repeat CRE bubble by its proper name:
"The growing bubble in the commercial real estate industry has the potential to infect our economy and slow a recovery," said Chairman Kanjorski. "In order to safeguard the businesses operating on Main Street and protect the millions of jobs depending on commercial real estate, the Treasury and the Federal Reserve now must take needed and urgent action to stave off a potentially devastating wave of commercial real estate foreclosures and bank losses."
Wait? What's that? CRE valuations are fair? Isn't that what Merrill Lynch pounds the table on in each and every REIT research report. Maybe, just maybe, bubble and fair value are synonymous - we are not sure.
Luckily, to provide the correct answer, S&P picks today to release their extended industry report titled: The Worst May Still Be Yet To Come For U.S. Commercial Real Estate Loans. From the summary, S&P notes the following:
Standard & Poor's Ratings Services believes that U.S. banks' real estate exposures may trigger substantial losses on the financial system during the current economic cycle. Each real estate cycle is different, and this one is likely to be different from the one during 1990-1993. In our view, however, that does not mean that this cycle should be any less severe. Although the causes of this cycle, and the players, are different, the sector nevertheless is likely to suffer the same degree of supply and demand imbalances and price declines that historically devalued the collateral backing real estate loans, resulting in severe losses for lenders. The severity of commercial real estate (CRE) cycles has always caused us to view CRE lending as one of the riskiest loan categories for banks. Therefore our risk-adjusted capital (RAC) methodology assigns a higher risk weighting for these loans than for most other asset classes. As a result, banks with high CRE exposure were generally rated lower than banks without this exposure.
In addition, elevated CRE exposure has driven many bank downgrades in the past two years, particularly of regional banks or finance companies with outsize exposures. Even though most highly exposed banks with weaker balance sheets are already rated below investment grade, more downgrades are possible; indeed, approximately 75% of the rated banks with the largest exposure to CRE carry negative outlooks. On a more positive note from a ratings perspective, even though many of the rated banks could suffer heavy losses, we believe that their capital is in most instances sufficient for them to pull through, as long as the losses are realized over a few years rather than taken at once, and as long as liquidity can be maintained. CRE exposure generally tends to represent a higher proportion of smaller, largely unrated community banks' exposures. Therefore, there is a greater proportion of risks in the unrated banking sector.
So there you go: even S&P confirms that should all losses be recognized all at once, without the aid of accounting and regulatory gimmicks, the financial system is likely entirely underwater, and this is only on account of CRE exposure, which as most pundits have been noting should not be a concern for anyone, as it is all under control. Right. One wonders how many of the other "manageable" risk factors are sufficient to destroy banking as we know it should mark-to-myth be replaced with some representation of reality.
To elaborate on its point, S&P provides the following color:
As we look at the fundamentals across the various sectors of CRE, we see that the homebuilding sectors were hit the earliest and the hardest. About 40% of rated banks' CRE loans are made for construction, acquisition, and development purposes, of which 22% (or 8% of total CRE loans) are for residential construction, a sector that has been particularly hard hit by a severe (79% from the peak) plunge in homebuilding that began in late 2007. As a result, builders have defaulted with greater frequency and undeveloped land has fallen in value, causing nonperforming loans in the homebuilding sector to rise to 18% as of Sept. 30, 2009. Homebuilder-related net charge-offs rose steeply to an annualized run rate of 4.8% for third-quarter 2009. More recently, commercial construction loans have gone sour as the fundamentals in those markets deteriorated.
Supply and demand imbalances are visible in all segments of mortgage lending as well. National vacancy rates in the office, retail, multifamily and hotel sectors are now in the neighborhood of 1991 levels. For example, office vacancies reached 17.3% as of third-quarter 2009, and C.B. Richard Elllis (CBRE) estimates they will go to 19.5% in 2010, higher than the peak of 18.9% in 1991. Likewise, retail vacancies, currently at 12.3%, are headed to 12.9% per CBRE estimates, versus 11.3% in 1991. Multifamily vacancies are at 7.4%, versus 7.0% in 1991. Nationally, rents for offices are down substantially more than in 1991--by 15.7% versus 9.4%. This time around, a particular trouble spot is the hotel sector, especially the casino hotel sector, where overbuilding has been a factor. The occupancy rate for this asset class is a low 60.9%, a level last seen after Sept. 11, 2001. Nationally, rents for offices are down substantially more than in 1991--by 15.7% versus 9.4%. RevPAR (revenue per room) for hotels nationally is down 20%. Real estate cycles generally lag the economic cycle, so vacancies could deteriorate further even as the economy recovers. This is due to the buildup of "shadow" vacancies of empty space still under lease but unutilized by strong companies able to make lease payments.
In addition to whole loans, S&P sees pain for those banks which have extended exposure in the form of CMBS. This is the rating agency's projection for those who have the greatest CMBS holdings:
Furthermore, the report indicates that Bank of America Merrill Lynch (surprise) has over $7 billion in equity interest in CRE. One wonders why the bank is so bullish on CRE in all of its forms.
S&P's conclusion, which hopefully will be considered by Kanjorski and Congress:
The fallout from CRE exposures for banks has yet to run its course, in our opinion. Although many of the problems are already evident in the homebuilding sector, and are well underway in commercial construction, these are the smaller sectors. We believe the problems in the larger mortgage and multifamily sectors are yet to be felt because fornow low interest rates and still-adequate cash flows make debt servicing possible. As rates rise and rent rolls decline further, we believe that delinquencies will rise in this sector as well, and prices will fall further, complicating the refinancing of these portfolios.
So you have the truth. And then you have ML REIT upgrades. In the meantime complacency is wonderful. It worked for so long, well, with one or two hiccups, why should it stop working now. We have a jobless recovery- when does it end: when unemployment is 100%? Think of all the SG&A savings! We also have a CRE industry that would not be able to refi at 100% interest rate should its true state be left exposed. And now that all systemic risk is borne by US taxpayers, why, you would be stupid to believe there is such a thing known as risk left in any investment decision.