Asset Allocation: Why Banks Need To Look At Rotating Exposure Away From Residential Loans

Asset Allocation

Next to C&I, commercial real estate ("CRE") loans have been one of the best performing asset classes for banks in 2014. Spreads continue to tighten on CRE and are expected to suck in another 8bp by year end making the future look bright. With banks coming up on their mid-year asset allocation review, all looks stable for the majority of bank asset classes with the exception of the difference between commercial real estate and residential mortgage holdings on bank’s balance sheet. In order to gain more insight, lets compare commercial loans to a residential loan benchmark.


To start, while both markets have performed well since bouncing off their lows in 2009, currently the residential market is showing signs of weakness given the decline in existing home sales (seven of the last eight months) and the 14.5% drop in new home sales compared to a year ago (largely as a result of higher rates). By contrast, CRE has almost all indicators pointing to continued growth.


One major driver of attribution is the jump in CRE property prices compared to residential real estate. Higher rents, occupancy and property values have outperformed equivalent metrics for residential real estate. In looking at prices, setting the baseline to 2000, prices for residential real estate across the nation are up about 150%, while commercial real estate has more than doubled. These positive cash flow and collateral value increases have substantively reduce the risk of CRE. Non-current loans in the industry are now down to 1.9% for CRE (62bp for C&I) and 4.1% for residential real estate. 


Part of the reason for outperformance has to do with larger inventory in residential real estate, particularly still on the balance sheets of Wells Fargo, Bank of America and other large banks. The other major risk factor is liquidity. For commercial real estate, liquidity has largely returned to its 2006 conditions – leverage is being employed, amortization is increasing, securitization markets are fully functioning and interest only loans are now common. In comparison, FNMA and FHLMC dominate the residential sector and the volume from private lenders pales in comparison to where they used to be. 


In terms of transaction volume, commercial transactions (an evidence of collateral liquidity) is now back to 61% of its November 2007 peak, while residential real estate is about 58% of its March 2006 peak. When looking at new construction activity, commercial real estate is back to its 2005 levels, while residential real estate is still below its 2002 peak.


So how does the future look?


Residential real estate loans, because of the floating rate caps or longer fixed rate nature, will underperform commercial real estate in the expected rising rate environment. Add to that tight underwriting standards and sluggish wage pressures, and the residential real estate loan market is expected to have negative return over the next five years as credit spreads should remain stable. In contrast, with the exception of some geographical markets and with some product (notably multi-family and retail), commercial real estate cash flow and hence values are expected to increase around 5% (thus tightening credit spreads) for another two years or more according to most models.


The net takeaway is that banks should be careful in expanding their portfolio of residential real estate. While credit performance is expected to remain stable, total return performance is expected to lag most other classes to include commercial real estate, C&I, consumer debt and agriculture. For banks that have not done so, the expectations warrant an asset reallocation to better deploy capital more efficiently and decrease residential real estate balances as a percentage of total lending exposure.