Making the Case for a Commercial Real Estate Crisis
The Congressional Oversight Panel, established in 2008 as part of the Emergency Economic Stabilization Act, turned its attention to conditions in the commercial real estate market with the release of its February oversight report last week. Titled “Commercial Real Estate Losses and the Risk to Financial Stability,” the report addresses the potential for further deterioration in commercial mortgage performance to spill over into the broader economy, thereby curtailing growth.
The Oversight Panel concludes that “a significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American.” As defaults and bank losses rise, the likelihood of a large number of bank failures increases. Because exposure to acquisition, construction and development loans and permanent commercial mortgage financing is concentrated on the balance sheets of smaller lenders, these sources of credit are at greater risk.
In clarifying the relevance of its investigation for legislators and the custodians of taxpayer resources, the panel’s report goes on to explain the critical relationship between the banks most at risk from the commercial real estate downturn and the nation’s small businesses: “Because these banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery and extend an already painful recession.”
For anyone familiar with our sector, the report’s underpinnings-a real estate sector that lags behind the broader economy, the recent history of securitization and the disproportionate contribution of regional and community banks in balance sheet lending-are well understood. Still, inasmuch as it draws new attention to the particular woes of the commercial real estate industry, the report has been well received by our representatives in Washington. In a statement coinciding with the report’s release, the Real Estate Roundtable offered that “[it] should be a must read for any policymaker looking to understand the scope of the problem and explore potential solutions.”
AS REFLECTED IN the Roundtable’s comments, the panel’s report deals extensively with the scope of the industry’s problems. Many of its conclusions are based on testimony offered by industry representatives at a late January field hearing on commercial real estate, held in Atlanta.
Citing data provided by Real Capital Analytics, the report describes how the volume of troubled assets is climbing and recovery rates are falling. While workout activity is increasing, the process can be protracted and costly. Of 8,651 mortgages and commercial properties currently in the process of foreclosure nationwide, in bankruptcy or in the workout process, restructuring and modification had been concluded for just 725 as of December 2009. Another 1,314 distressed mortgages had been resolved through refinancing or a property sale.
The facts regarding commercial real estate market conditions presented in the report are not a point of dispute. Where the report fails, however, is in fully addressing the issues that remain open to debate. Most important among these issues is the causal path that links commercial mortgage performance to the broader economy, principally through the channel of small business lending by regional and community banks. The report describes the issue but regrettably stops short of offering a rigorous, analytical assessment of the likelihood that each link in the causal chain will reach a crisis point that triggers the threatened cascade.
Washington’s inertia in addressing the commercial real estate crisis is a result, at least in part, of a lack of consensus on the very question that the report raises without fully addressing. Many well-informed policy makers and real estate market participants doubt that commercial real estate’s direct and indirect effects on the wider economy are of sufficient size and scope that they present a source of systemic risk.
A broadly appealing case that policy makers must act now eludes the reader of the panel’s report. Absent a definitive statement around which to build consensus, the political will to fully address the commercial real estate crisis may not emerge until its impact on the American economy is readily apparent.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.