CRE Loan Losses Could Trigger Financial System Disruption

COVID-19 economic turbulence has pushed global property prices down 6% so far this year, but things could get worse, according to a report from Adam Slater, lead economist for Oxford Economics.

Slater is concerned that the COVID-driven slump has the potential to trigger a longer-term disruption in the financial system. While baseline CRE loan losses are lower than the losses incurred during the global financial crisis, he says that losses are comparable in downside scenarios. 

But COVID could put unique strains on the system not seen during the global financial crisis. It could lead to lengthier downturns in some sectors that could result in loan losses exceeding the level seen during the Great Depression. Commercial property bonds issued between 1922 and 1931 showed default rates of up to 70% (for later vintages) and an average loss rate of some 25% of original balances, according to research from Oxford Economics, Haver Analytics, PennMutual, Moodys, Trepp and Wiggers & Ashcraft.

During the COVID crisis, the delinquency rate on US commercial mortgage-backed securities has jumped to around 10%. That level is similar to what was incurred during the global financial crisis when US CRE loan losses hit about 7% of the value of loans and CMBS losses hit 14%.

Already, Trepp has pinpointed about $3.9 billion in almost 100 outstanding CMBS loan balances where the borrower has indicated a willingness to turn over the asset to the lender.

“It is likely we will see continued deterioration in the performance of various mortgage loan classes as we move closer to the end of 2020,” J.D. Blashaw, VP at MetroGroup Realty Finance, told GlobeSt.com in an earlier interview. 

But there are some positive signs. Slater says bank capital and leverage ratios are double the level of a decade ago, which means they should be in better shape to absorb losses. Even then, CRE loans could be destabilizing for certain banks.

In Slater’s worst-case scenario, loan losses would erode bank capital. In the early 1990s and 2008-2011 crises, CRE loan losses accounted for 25% to 30% of total loan write-offs, according to research from Oxford Economics and Haver Analytics. Often those losses are accompanied by issues in other lending types during a steep recession, according to Slater. Many small- to mid-size enterprises, which could be facing financial stress, have loans that are collateralized by commercial property. 

“Bank credit standards for CRE loans have already tightened sharply in the US and this is likely to feed back into even lower CRE prices and more loan delinquencies,” Slater writes. “If loan losses are large enough, this could also spill over into tighter credit standards to other loan segments… .”