Commercial Real Estate Outlook Sours for Banks

This story originally posted on RealMoney.com on Feb. 9. For more information about subscribing to RealMoney, please click here.

For many large banks, exposure to souring commercial real estate and construction loans began to reach alarming levels during the fourth quarter of 2008.

Moody's Investors Service announced Thursday it was reviewing $303 billion in commercial-mortgage backed-securities, saying commercial property prices were likely to decline over the next two years. But that outcome should not be at all surprising, considering that a commercial real estate swoon was a logical follow-up to the housing crisis and expected recession.

While every commercial construction loan is different, they typically have a term of 20 years, with an "interest-only" period of one or two years during construction, followed by an 18- or 19-year amortization with principal and interest payments. Over recent years, banks have commonly set aside reserves to cover the interest during the construction phase, so the borrower pays nothing to the bank during that period. Of course, the borrower will pay a higher rate or fee (or both) for this privilege.

Since so many commercial construction loans with interest reserves are reaching the end of the construction phase now -- facing the prospect of having no tenants in completed structures because of the weak economy -- lenders realize the borrowers (who often flew by the seats of their pants) are unlikely to make even the first fully-amortized loan payment and the loan is placed in nonaccrual status.

Combine this phenomenon with already-existing commercial buildings facing vacancies from retail bankruptcies, and you have a perfect storm for commercial real estate on the heels of the residential mortgage crisis.

Large Banks with Heavy Nonperforming CRE Exposure

When TheStreet.com reported in December on the ten large banks (over $10 billion in assets) with the highest exposure to nonperforming commercial real estate (CRE) and commercial construction loans (CCL) based on Sept. 30 data, the highest ratio of these loans to total assets was 5.07%, and three of the banks on our list had a ratio below 1.00%.