Although commercial real estate loan charge-off and delinquency rates are still relatively low, the total amount of debt and values are not sustainable.

Commercial Real Estate Debt

According to Mortgage Bankers Association the level of commercial/multifamily mortgage debt outstanding increased by $45.4 billion to $3.11 trillion in the third-quarter 2017. Commercial banks continue to hold the largest holders of commercial and multifamily mortgages at $1.3 trillion or 40 percent of the total. Agency and GSE portfolios and MBS are the second largest holders of debt, holding $573 billion or 18 percent of the total. Life Insurance companies hold $454 billion or 15 percent of the total and CMBS, CDO and other ABS issues hold $431 billion or 14 percent of the total.

Current Pricing

According to the value-weighted Costar Commercial Repeat Sales Index, commercial Property prices have risen steadily since the beginning of the recovery from the Great Recession through September 2017, and now are nearly 25 percent above the level at the end of 2007.

Prices of multifamily properties are nearly 50 percent above their end-2007 value

According the National Association of Realtors Commercial Real Estate 2017 Outlook, the NCREIF Property Index for Third-Quarter 2017, was as follows:

Type Return

National 1.70%

Office 1.40%

Industrial 3.29%

Retail 1.20%

Apartments 1.66%

When you have a fixed-income, comparatively illiquid investment priced with little to no risk premium (e.g. 250 bps to 300+ bps over 10-Treasury), any number of market factors can cause significant disruption in real estate pricing.

Macro-Economic Factors

According to Trading Economics’ December 2017, study, the household savings rates in the US decreased to 2.40 percent in December 2017 from 2.90 percent in November 2017. Personal savings in the United States averaged 8.27 percent from 1959 until 2017, reaching an all-time high in May of 1975 of 17 percent and a record low of 1.90 percent in July 2005.

The Wall Street Journal, December 22, 2017, said that savings rates are at the slowest pace in a decade, likely in anticipation of continued job and wealth gains (from tax cuts, deregulation, etc.)

The personal savings rate fell below 3 percent for the first time since November 2007, just before the last recession

Consumer debt is now at $13 trillion, exceeding its peak in the third quarter of 2008

Alberto Gallo, wrote, in the Bloomberg View, October 5, 2017, A Volatility Trap is inflating Market Bubble, that there are a number of potential risks that could cause a significant downturn. He pointed out what appears to be a “Goldilocks” economy could in actuality conceal a low-volatility trap, a situation where excessive monetary stimulus keeps asset prices rising and volatility low across markets even though real-economy risks are rising. Further to this point, Justin Colletti, stated in his article, The Great Bubble of 2016 (...and 2017), that history shows that credit bubbles tend to pop every 7-9 years, and it appears that the next big bubble pop may be upon us now. He points out that the risks are much greater with several simultaneous bubbles occurring at once: in student loans, in consumer car loans, in private debt, government debt, real estate, and [derivative exposure].

Daniel LaCalle, PhD, wrote in Focus Economics, Risks and Opportunities for 2018, that last year was the biggest debt binge in fifteen years.

The world added more than $16 trillion in debt to reach more than three times the size of annual GDP

He further stated that massive monetary stimuli and very low rates have created a monster incentive to take more debt. The biggest concern, he stated, about this debt binge is that solvency and liquidity ratios are not improving. Inflation is creeping up, and bondholders may find themselves with large nominal and real losses as rates remain consistently below headline inflation. Furthermore, he points out that investors are financing increasingly higher risk debt expecting more growth than consensus estimates and weak inflation. This is a dangerous combination.

What Banks and Special Conduit Servicers Can Do Now

There is going to be a market correction. The question here is whether we will be prepared for this downturn and have in-place the qualitative and quantitative analyses and processes to maintain our required capital reserves and outperform others in our sector.

The regulators will require that there be a risk management process that periodically looks at credit, market, product type, special purpose, industry, and use concentration and correlation risks factors.

Stress testing should be done on both a transactional and portfolio basis

Stress testing should be done on real estate loans to analyze current and future risks and vulnerabilities by assessing the impact of changing economic conditions of a borrower’s performance to determine future loss rates. Also, stress testing can show the impact on the bank’s earnings, loan loss reserves and capital levels.

There is a saying in asset management that “when the market is up it is never down, and when the market is down it is never up.” This saying highlights the danger of group think and how sometimes we can’t see what should be obvious. In conclusion, the take away is this: “Better is an ounce of prevention than a pound of cure,” Benjamin Franklin.

#realestaterecession #commercialrealestatedebtlevels #loanlossreserves #realestateconcentrationrisks #commercialrealestateloandefaults