Even as cases of Covid-19 increase globally, the arrival of viable vaccines promises a return to something resembling normality by the middle of next year. But the commercial real estate industry may never return to normal, which could cause problems for banks.
Many banks are concentrated and dependent on commercial real estate loans. Banks hold half of all commercial real estate loans. The roughly 5,000 US community banks, with about a third of total assets, are two to three times more concentrated in commercial real estate lending than the 30 or so large banks.
Problems in commercial real estate can hurt banks in two ways. Losses on existing loans can directly hurt earnings, and a correction can reduce future loan volumes, thereby compromising an important earnings driver. From what we know now, things don’t look good.
Neiman Marcus and at least 28 other major retailers have filed for bankruptcy. The occupancy rate of hotels is down 32%. The Journal reported last month that global airline capacity in October was down 58% from 2019. Apartment rent levels slumped 15% to 25% in major cities like New York, San Francisco, Boston and Seattle. Suburban malls have been devastated.
report on 400 properties in the retail and hotel sectors found an average drop in value of 27%. Stock prices of real estate investment trusts, companies that hold equity in commercial properties, are down 42% for commercial properties since the last valuation before the pandemic began in March. Office real estate REITs are down 36% and accommodation real estate REITs are down 50%, all despite the recent market rally in vaccine news.
Some of the pressure on commercial real estate is undoubtedly temporary. Leisure and business travel are expected to recover gradually, which will help the travel industries. Recent college graduates who lived and worked out of their parents’ home will eventually move, which will drive the recovery of apartment rental markets. With a vaccine distributed, customers will likely return to restaurants and bars.
But some more permanent changes in the commercial real estate market are just beginning to take shape, driven by the acceleration of pre-existing trends. The decades-long shift to online retailing has accelerated this year, with serious implications for traditional retail properties. Many companies take a close look at their desks and conclude that they need them much less. Likewise, banks are downsizing their branch networks as the pandemic sweeps away customer concerns about mobile banking. “What is clear is that consumer behavior has changed, and my belief is, in many ways, that it has changed permanently with this digital adoption,” said William S. Demchak, President – Managing Director of PNC Financial Services. “We’ll have to adjust the way we serve our customers, and it’s likely that will mean less physical space. ”
It’s not all bad news. Companies like
flourished, increasing the demand for warehouses and distribution spaces. Stock prices of data center REITs are up 23% this year and industrial REITs are up 9%. But these types of properties command much lower rents than office and retail businesses. And the good performance of one type of property is a modest comfort for a lender facing losses on retail, office or accommodation properties.
For properties financed with typical debt levels of 75-80%, even a 30% drop in value, if sustained, is more than enough to push the property underwater. The decline in temporary factors may improve this picture, but emerging long-term factors will make matters worse for many properties. If the downdrafts of a specific property are entirely temporary in nature, and owners have the resources to stay afloat (or secure them through future government assistance), perhaps even submarine properties do not. will not become total losses. But how many shops, offices and housing will ultimately be so well positioned?
Today, banks are doing well and their wide exposure to commercial real estate is not yet a problem. Hopefully this continues, but the available facts suggest that a few tough years lie ahead. Many, including community banks, will weather this storm in good shape thanks to a combination of loan diversification, careful underwriting and good fortune. Unfortunately, not everyone will have this chance.
Mr. Graham is a partner and co-founder of the Klaros group.
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Published in the print edition of December 15, 2020.