Commercial Real Estate Finance

From a recent article on Bloomberg:

“Among 35 of the biggest regional lenders that retain TARP funds, commercial real estate and construction loans average 37 percent of total loans, compared with 9.5 percent at Citigroup Inc. and Wells Fargo & Co., the two biggest U.S. banks that haven’t announced plans to repay the government, according to data compiled by Bloomberg.”

In a word, “Oy!!”

Folks, if 37% of the loans currently on the books of regional banks are commercial real estate and construction loans… well, it’s not a good thing for the banks.

What do I mean by ‘not good’? How does wiping out 1/3 of bank capital without breaking a sweat sound?

A brief explanation:

Banks, believe it or not, are more highly leveraged than real estate deals. In fact, a well capitalized bank is 10% equity supporting 90% leverage.

The next thing to figure out how much of a bank’s balance sheet is in loans (as opposed to bonds, cash…etc.). A quick search of the internet reveals the balance sheet of a typical, well run, regional bank. This bank has 75% of its assets in loans.

Now we have all the pieces to make a model. As we all know, in real estate, we don’t need much to make a model.

Assuming the bank is levered 90%, a 13% drop in the Commercial loan portfolio means a loss of 34% of bank equity; without losing a penny on any other assets!!

With a little more math, we can make a nice round guess as to what that means in the underlying real estate. While there are  myriad combinations, I used a 15% drop in NOI and a 150bp increase in cap rates. From where I sit, this would be a good version of typical deals.

Excel junky that I am, I couldn’t resist doing a little sensitivity study. Not that you asked, but I see the gray shaded area as very well within the realm of possibilities.

How does this relate to you, the well informed commercial real estate professional? Well, how are these banks going to get their capital back? To start, Uncle Sam is cutting checks. A fine solution when the world is coming unglued. Now that we’re losing less than 50,000 jobs a month, however, I’m wondering how the US tax payer is going to get their money back. There are two ways that I’m aware of: selling stock and selling assets.

On selling stock: The big guys took this rout to the tune of $1.5 trillion (with a “T”), so I think the regionals will at least try. From a portfolio perspective, as a US citizen, I consider myself already long more bank stock than I want. So, when the brokers call to sell me the new bank share issues, I’m going to pass.

On selling assets: Here’s the one we’re rooting for. If the banks actually begin to sell assets, then the market for commercial real estate might pick up. This is the “get the garbage off the balance sheet” solution everyone talks about. Two things would happen: 1) price discovery will at least give market players something to hang their hat on regarding value, and 2) the banks will actually have capital available for NEW real estate loans.

Key takeaways:

• Regional banks are in a very tough spot and commercial real estate continues to make things worse

• If regional banks don’t get this sorted out before the Fed starts to seriously address the potential for inflation, the commercial real estate industry could suffer for even longer.

Editor’s Note: If you would like to receive the accompanying Excel model, please send an email to info@llenrock.com with “Excel Model Request” in the Subject Line.

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