Small U.S. Banks and Commercial Real Estate: A Doom Loop?

Analysis

Photo by Andrii Spy_k / Shutterstock.com

There is the possibility of a negative spiral developing between small U.S. banks and commercial real estate, Finance Matters columnist Les Nemethy warns.

Here’s a step-by-step breakdown of what the scenario looks like:

1. Small banks in the United States hold more than 70% of commercial real estate loans.

2. Prices on most types of commercial real estate in most localities are falling; in some major cities, it is estimated that 90% of properties are “underwater” (the debt on the properties exceeds the value of the property).

3. A flight of deposits from small to large banks and money market funds decreases the capital available for real estate loans.

4. A tighter loan market, including higher interest rates, is also making it more challenging to refinance real estate.

5. If current owners of commercial real estate cannot refinance, a wave of defaults may ensue, leading to further decreases in commercial real estate prices and bankruptcy of small banks, a negative spiral or doom loop.

Now that I have laid out the big picture let me provide more color and context on each of the above points.

1. Small Banks and Commercial Real Estate

Small and mid-sized banks (in other words, all except the top 25 banks) hold more than 67% of commercial real estate loans. Commercial real estate constitutes some 43% of small bank loans in the States.

2. Commercial Real Estate Prices are Falling

Commercial real estate prices have fallen about 5% since their peak in mid-2022 and are forecast to drop 15-20% further as the cycle plays out:

The chart is based on U.S. national averages. In cities hit by particularly high office vacancy rates (Los Angeles, for example), the situation is much worse. According to real estate consultancy Colliers, L.A. office towers carry an average of more than USD 230 debt per square foot, while the market value is USD 154/sqft. Brookfield, the city’s biggest commercial landlord, defaulted on more than USD 1 billion in loans this year.

In the United States, it is estimated that approximately USD 1.5 trillion in commercial real estate loans are coming due by the end of 2025, with the potential of being underwater. This will create distress sales and further depress real estate prices.

3. Flight of Deposits From Small Banks

In the second half of March 2023 alone, some USD 230 bln in deposits were withdrawn from U.S. small banks. While the situation since has more or less stabilized, this withdrawal leaves a gaping hole in the ability of small banks to finance and refinance commercial real estate. Further flights of capital remain possible. Understandably, small banks have become much more cautious about commercial real estate lending.

While increasing interest rates have caused bond values to fall, under current regulations, banks do not need to write these down to market value if held to maturity. Hence, although healthy on paper, according to Professor Amit Seru of Stanford University, almost half of America’s 4,800 banks have, de facto, burned through their capital buffers.

Isn’t it ironic that U.S. Treasuries, meant to be the pillar of stability of the global financial system, are now its Achilles heel? All because the Fed acted irresponsibly in artificially depressing interest rates for years, then slammed on the brakes with the fastest rate hikes in U.S. history.

4. Tighter Loan Market

The prime rate (which banks charge to their most creditworthy customers) has shot up from just above 3% at the end of 2020 to just above 8% as of May 2023. Interest rates expense for loans about to renew or variable rate mortgages has almost tripled over three years. Many bankers also talk of tighter terms and conditions (coverage ratios, percentage of collateral, etc.)

A significant source of liquidity for mortgage markets, Commercial Mortgage-Backed Securities, where banks securitize and resell bundles of mortgages, have virtually seized up. As of March 2023, the volume of CMBS lending declined by 85% compared to a year ago, further tightening the loan market.

5. Negative Spiral

The above amply demonstrates the potential for a doom loop; this risk further increases in the event of a recession. At the highest risk will be those properties with floating rate mortgages or mortgages expiring soon. There is also the potential for contagion. A foreseeable contagion would be towards municipal finance, as the amount of property tax paid by commercial real estate owners could drop dramatically.

According to Fed chair Jerome H. Powell: “We’re well-aware of the concentrations [.…] in commercial real estate [….] the banking system is strong, it is sound, it is resilient, it’s well-capitalized.” Is he talking of the same banking system?

Professor Seru’s interpretation is, unfortunately, perhaps more credible: “A lot of the U.S. banking system is potentially insolvent.”

Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.

This article was first published in the Budapest Business Journal print issue of June 2, 2023.

ADVERTISEMENT

Industrial Producer Prices Down 6.8% in January 2024 Figures

Industrial Producer Prices Down 6.8% in January 2024

Hungary Makes Proposals to Ease Administrative Burden for EU... EU

Hungary Makes Proposals to Ease Administrative Burden for EU...

Colette Matz Named New Country President of Novartis Hungary Appointments

Colette Matz Named New Country President of Novartis Hungary

Investors of the Year in Limelight at Hipa’s Award Ceremony Awards

Investors of the Year in Limelight at Hipa’s Award Ceremony

SUPPORT THE BUDAPEST BUSINESS JOURNAL

Producing journalism that is worthy of the name is a costly business. For 27 years, the publishers, editors and reporters of the Budapest Business Journal have striven to bring you business news that works, information that you can trust, that is factual, accurate and presented without fear or favor.
Newspaper organizations across the globe have struggled to find a business model that allows them to continue to excel, without compromising their ability to perform. Most recently, some have experimented with the idea of involving their most important stakeholders, their readers.
We would like to offer that same opportunity to our readers. We would like to invite you to help us deliver the quality business journalism you require. Hit our Support the BBJ button and you can choose the how much and how often you send us your contributions.