First, let’s stipulate that we really have no idea where we are in the real estate cycle. We recognize that this is less than stellar opening sentence and one that doesn’t inspire confidence, but we don’t want to mislead. That said, since we are forced for management and regulator purposes to monitor the real estate business cycle, we have a model that looks at each major commercial real estate sector and predicts where we are in the economic cycle. For ease of understanding, we have equated the real estate cycle with the proverbial baseball game. Any sector or geography that is in the ninth inning, we want to start to divest. As sectors or areas get past the seventh inning stretch, we want to increase monitoring, adjust pricing, increase credit standards and reduce marketing expenditures.
Part of our lack of clarity comes from the long period of low rates that we have been through, the depth of the recession, the new level of regulations and the uncertain world we live in given the recent events of Brexit, anti-trade rhetoric, immigration, excess liquidity and tax reform. We are already above 2006 collateral value levels for most CRE sectors, but the shape of the recovery, strong corporate earnings and dampened relative real estate speculation causes us some comfort.
This month marks the eighth anniversary of the recovery that started back in June of 2009. That makes it the third longest postwar recovery on record and at 96 months, it is now almost twice as long as the average postwar recovery term of 58 months. At our current pace, we will likely surpass the second longest expansion clocked in at 106 months between 1961 and 1969 and could possibly surpass the longest economic expansion on record which was the 120 month run that took place between March of 1991 and March of 2001.
Gross domestic product growth is on track to bounce back to a 3.7% annual rate in the second quarter and with some regulatory, tax reform and new trade deals, the 3% target is well within our reach for the foreseeable future. More importantly for commercial real estate, over the last three months, job growth has been averaging 174k per month, or about two times what is needed to keep unemployment from rising.
While commercial real estate has been screaming hot putting in a 7.9% appreciation rate in 2016 according to Moody’s/Real Capital Analytics, it appears that national property price growth has slowed to a 4.2% annual pace.
Delinquencies and losses have been relatively minor and have centered around agriculture, energy, and businesses in those geographies that relied on those sectors. By loan sector, retail has been hit and both hospitality and multifamily are likely nearing an end to a phenomenal run.
Loss given defaults for banks have been averaging around 20% with most of the issues coming from 2012 originations followed by the 2010 and 2014 vintages (below).
Looking at a combination of current vacancies, new supply (permits), net effective rents, absorption and asset prices, our model looks at the upside of CRE lending vs. the downside. We look at growth numbers relative to past cycles and adjust for changes in GDP.
What follows is a breakdown by metro area and loan sector. We equated the ninth inning to a point in the cycle just past the peak where metrics are steadily decreasing but before where there is a reduction in liquidity in the market. This ninth inning mark is somewhat predicated on past cycles, so the question comes up is given our period of low rates and current liquidity in the market, how much higher can the peak get without a material increase in risk. We are unsure, but have taken our best guess below and assume we can increase our peak 10% to 15% greater due to greater relative liquidity.
The other factor that we have taken into account is the year-over-year net change. Thus, areas such as Orange County, CA, or Long Island, NY, have had very positive performance but because of the huge potential increase in product supply in certain areas, it has set off alarm bells.
Geo and Sector Analysis
As can be seen below, multifamily represents the largest risk to the banking industry due to current trends and oncoming new supply. Th office sector has undergone the most rapid change and merits a higher risk focus going forward.
More granular details can be found below:
Submitted by Chris Nichols on June 08, 2017