Predictions of a commercial real estate crisis have circulated for better than a year.
While a downturn is likely, it won’t be as bad as doomsayers are predicting.
Unlike the residential crash, the downturn will be concentrated in small, community financial institutions rather than regional or national banks.
The fear of a commercial real estate crisis is an outgrowth of the recession caused by the crash in the residential market. While the similarities are compelling, there are some important differences between the two.
The residential lending market was as much a trading and investment crisis as a loan crisis. Mortgages were deconstructed and synthesized as high quality investments, where they were resold to large and small banks. When the default rates exposed the sub prime quality of these instruments, bank capital fell in large and small banks together. Fannie Mae and Freddie Mac became wards of the state, and the big mortgage banks – WAMU, NatCity, Countrywide, Wachovia – were driven into shotgun weddings with stronger institutions. Only banks with diversified businesses thrived.
Commercial real estate by contrast is significantly more concentrated in smaller banks, with less repackaging of loans. And the risk of these loans is likely to be worse for small banks.
The biggest problem in the residential mortgage crisis was the excess valuation of housing. The residential appraisal business is partially to blame. It is a cottage industry, poorly regulated and subject to fraud and abuse. Banks went along with valuations, assuming that they were safe as long as people cared about their homes, and housing prices kept rising. Then everyone started inflating property values, leading to faulty assumptions about repayment rates. Ultimately we relearned that when the value of a property is less than the amount of the outstanding loan, the borrower acts rationally and walks away.