Commercial Banking in Jeopardy ?

[Dave E.]

I am far from an expert as I don’t currently invest in commercial real estate, but I have to admit that I am getting concerned with the commercial banking side (commercial loans).  I hesitate to post this as my experience is limited, but I don’t have a lot of connections close to the commercial lending and real estate markets. Just looking to expand my knowledge base and get some feedback. (Maybe I’m just paranoid lol). These are just my personal observations and gut reaction to what is going on in the world at the moment.

There are obviously several different sectors to commercial real estate.  From a layman’s perspective, there are three that I am specifically concerned about:  Apartments, Retail/Bars/Restaurants, and Office.  In most cases there is a landlord, or developer that owns the property and they have tenants that rent out the space.  The property owners also likely have commercial loans or mortgages on the properties, and they rely on their tenants to pay rent so that they can make their loan payments. 

·        Apartments – lots of unemployed tenants that can’t (or won’t) pay rent.  Due to eviction restrictions that have been put in place in most areas, management companies can’t evict tenants that are unable to pay rent for the foreseeable future.  Good for the tenants, and I understand why it is in place, but bad for the property owner that must pay their commercial loan each month.

·        Retail/Bars/Restaurants – These brick and mortar businesses have either been closed or operating at limited capacity in many areas due to covid.  If they aren’t selling product/food/beverage, they aren’t making money to pay their rent, and they also are laying off their employees which contributes to people not paying rent at their apartment above.  Many of these businesses are closing their doors, and no one is lining up to take over their lease.  Throw in a dose of looting in larger cities (where I live) and it compounds the issue.  So we have another group of property owners that is getting reduced or no rent and still must pay their commercial loan each month. 

·        Office – There are millions of square feet of commercial office space that are not being used right now due to work at home options.  Many companies have adapted to this, and will reduce the amount of office space that they lease when it is time to renew (assuming they survive that long).  This is good for the companies that rent the space as they can reduce cost.  However, it is bad for the property owner who will either have vacant office space or have to reduce rent to get available space leased when demand drops through the floor.  Either way the result is reduced income for a property owner that still must pay their commercial loan each month. 

I am also concerned with how commercial real estate is valued in many cases.  The way that I understand it, banks generally value commercial property by how much income it generates, and essentially back into a property value from there.  I am completely over simplifying, but that is the general idea.  If rental income drops across the three sectors listed above, so do the property values.  Suddenly you have a group of property owners that are upside down on the commercial properties that they own.  They get into trouble.  Can't make their loan payments, and can't sell the property because the numbers don't work out anymore and then we start seeing foreclosures.  

The stock market is driven by confidence and by fear not by reality.  If these property owners start defaulting on their loans the commercial lending side of the banking system will take a hit and fear will result.  It could have a similar impact on the stock market to 2008 when the residential lending side hit the fan.  Anyway, that's my thought process.  It turned into quite the dissertation. I’m far from an expert, but these are the dots that are connecting in my head as an outside observer.

Talk me off the ledge. Curious what other people’s perspective is?

[Jason Wray]

Dave, Commercial banking will be just fine and this market will adjust after this election period. Rates will eventually go up and things will swing back to the norm. Real estate and banking have always followed some what of a cycle of a high followed by a low. Keep in mind Commercial equity sometimes banks on defaults. That is why you will always have to have a good chunk of equity as a DP (skin in the game). They look at deals with the intention of owning that property that is why it revolves mostly off of cash flow/NOI. Location is also key because as a store front with measurable traffic means it's not hard to sell that immediately to another investor looking to crunch the traffic numbers.

Here is the biggest problem if you let yourself worry or become a skeptic.  Right now while everyone is scared stiff over Covid-19 and absorbing themselves in the media and pre-voting garbage.  Investors are getting rich and setting up their future portfolios and collecting real estate with an all time low mortgage rate market.  People are going to look back and wonder how they let this opportunity slip by without grabbing up some real estate while rates are so low.  So I would not worry about commercial it's going to be just fine.

When someone looses a home due to default there is an investor waiting to scoop it up and either flip it or rent that property back out.  Starting the cycle over once again to keep our markets on the ever changing roller coaster ride that it has always been on since day one.