Commercial Real Estate: The Next Bubble?

Fed Chairman Ben Bernanke may have declared the recession at an end, and credit may be flowing again. But there’s a dark cloud hovering over the banking industry and financial sector: commercial real estate. On a recent walk along Manhattan’s Fifth Avenue, I counted a dozen empty storefronts and for-rent signs, more than I can ever remember seeing along this fabled stretch of high-end retail space.

The collapse of residential real estate, especially the subprime-mortgage sector, has received enormous attention and press since last year’s panic. But as the residential market has shown signs of stabilizing, the commercial market has emerged as a potentially greater threat. There are $3.4 trillion in commercial real estate loans outstanding, with more than half of that owned by banks. Banks have been slow to mark down the value of these assets; Goldman Sachs estimated that banks are still carrying their commercial mortgages at an average 96 cents on the dollar.

No wonder the Federal Reserve has signaled its growing concern. I’m told that some within the Fed are advocating a new round of stress tests for banks with significant commercial real estate exposure. Goldman Sachs recently raised its estimates for total losses on commercial mortgage loans to $287 billion, of which $180 billion, or 63 percent, will be absorbed by commercial banks. Indeed, a collapse in this sector could prompt a crisis that rivals last year’s meltdown in severity.

The gloom in real estate circles is palpable. I’ve attended several conferences where the mood and the discussion have been bleak. But is anyone listening? Bank stocks, even those with heavy commercial exposure, have enjoyed a stunning recovery this year, and so have real estate investment trusts, up 92 percent from their March lows. But something has to be wrong with this picture. If commercial real estate poses the threat that many are talking about, then bank stocks are overvalued, perhaps grossly overvalued.

There’s no question the commercial sector has suffered massive losses. The commercial mortgage-backed-securities market barely functions. Optimists argue that the sector’s problems are likely to be contained because they’re valuation-driven, a result of easy credit and the inflated prices it encouraged. This is in contrast to more typical real estate slumps, which are driven by overbuilding and oversupply. Without high vacancy rates, optimists argue, prices should stabilize. But vacancies have been rising sharply, especially for apartments, retail and industrial space. Goldman Sachs now predicts that asset prices will fall 40 to 42 percent on average. Private-equity firm Blackstone has marked down its commercial real estate portfolios by 45 percent. Rents are dropping at a 9 percent annualized rate, the worst decline on record.

These developments put all kinds of stress on bank balance sheets. Falling rents make it difficult for borrowers to make their interest payments, let alone repay principal. Banks refer to this as debt-service-coverage ratios, and as that ratio declines, the risk of default grows. A ratio of less than one means that income will not cover the outstanding loan. Analysts estimate that loans with ratios that low will rise from a negligible level as of 2008 to 49 percent of all loans by mid-2010.

Falling property prices affect another key metric, the loan-to-value ratio. Goldman Sachs forecasts that this ratio will reach 117 percent by 2010 and that 81 percent of commercial borrowers will be looking at negative equity. This gives them an incentive to simply walk away and cede an underwater asset to the bank, creating another enormous headache.

These looming problems have been on the radar of sophisticated investors for more than a year. But as residential real estate has shown signs of recovery, many investors seem to have lumped all real estate together, assuming the worst is over. In fact, we probably haven’t yet seen the worst in commercial defaults. While this likelihood should already be reflected in stock prices, my faith in efficient market theory was sorely tested by the financial crisis. Stocks in general, and bank stocks in particular, kept hitting new highs in 2007 even after rising default rates in subprime mortgages were the subject of widespread press coverage. Only when banks started taking multibillion-dollar write-downs did investors finally wake up to the scope of the problem, and then they overreacted.

I suspect something similar will happen with commercial real estate. All it will take is a highly publicized bank failure due to commercial loan losses, or a huge write-down from a household name bank, or perhaps another round of stress tests, to set off a new panic. And even if that doesn’t happen, earnings of many banks are going to be depressed for years by loan losses.

How should investors prepare for this? I have shrunk my exposure to banks by selling most of my positions into this year’s rally. The only bank stocks I still own are three that I recommended last year because they had minimal exposure to residential real estate: Northern Trust, SVB and UMB Financial. Similarly, the only bank stocks I’d hold now are those with low exposure to commercial real estate.

By and large, the banks with the lowest percentage of commercial real estate assets are large “money center” banks with big consumer operations and strong reserves. According to a Goldman Sachs report, the banks with the lowest exposure were Citigroup (3 percent of all its loans), JPMorgan Chase (9 percent) and Bank of America (11 percent). Those with the greatest exposure tend to be regional banks that also have large outstanding construction loans. Las Vegas–based Western Alliance Bancorp had 65 percent of its loans in commercial real estate; Zions Bancorp, headquartered in Salt Lake City, had 56 percent. Banks with less overall exposure, but with high concentrations of commercial construction loans, include Fifth Third Bancorp, BB&T Corp. and Regions Financial Corp.

As for commercial REITs, many have improved their balance sheets, and some may be in a position to take advantage of depressed prices. But I don’t believe that REIT shares reflect the continuing deterioration in commercial real estate. I’d continue to avoid the category entirely.

All this is likely to change if panic, or even a significant correction, strikes the banking sector because of commercial real estate losses. In that event, investors are likely to overreact, creating some compelling buying opportunities. When that happens, I’ll look to add to my bank positions, starting with the best capitalized and those least exposed to commercial defaults.