This article is from the Australian Property Journal archive
AUSTRALIAN banks are among the most at-risk of an extended fall in commercial real estate values, as the coronavirus-driven slump threatens to trigger long-term financial disruption.
A new paper from Oxford economics says global commercial property prices are down around 6% year on year so far in 2020, and the slide in prices could extend considerably further.
“Commercial real estate (CRE) loan losses have been heavy in previous downturns and we see worrying signs the same could be true this time, with rising delinquencies and falling prices visible in several economies,” Oxford Economics’ lead economist, Adam Slater said.
Slater said that bringing together a number of the potential risk factors related to CRE lending, such as recent price dynamics, loan growth, and the share of CRE loans in total bank loans, risks vary significantly across economies.
“The highest risks look to be in the US, Australia, and parts of Asia including Hong Kong and South Korea. In these economies, recent price and lending growth has tended to be high, loan exposures are significant, and prices are already sliding – especially in Hong Kong.”
From a sample of 13 major economies, Oxford Economics expects write-offs of 5% of loans would amount to 1 to 10% of tier 1 capital, with the biggest impacts in Asia.
“While nasty for the worst-hit, losses of this magnitude would not seriously threaten banks’ capitalisation,” Slater said.
Moodys and Trepp have recently published estimates of possible CRE loan losses over the next few years of 2 to 4% a baseline, somewhat below GFC levels. However, downside scenarios show losses comparable to those in the GFC – 5 to 9% of loan values – and there are good reasons for thinking that loan losses could even be greater this time, Slater said. If write-offs reached 9% of loans, similar to Moodys’ downside estimates, this would amount to 9% of tier 1 capital on average.
A worst-case scenario modelled on the Great Depression era, with default rate of 40% and loss given default of 40%, write-offs would average 16% of tier 1 capital and 20 to 40% for the worst-hit economies.
Write-offs of CRE loans have made notable contributions to bank losses in the last two major downturns. In the US, in both the early 1990s and GFC, CRE loan losses accounted for 25 to 30% of total loan write-offs, and in the GFC totalled some US$110 billion.
“In our worst-case scenario, CRE loan losses would materially erode bank capital. But the impact of weakening CRE markets could go beyond this as many SME loans are also linked to commercial property,” Slater said. “There is also a considerable risk that CRE weakness could spill over into a broad-based tightening of credit conditions and weaker growth.”
Germany stands out as riskiest market in Europe, with rapid loan and price growth in the last five years. Other economies, including the UK, Switzerland, and Denmark, however, show little evidence of a recent boom in the CRE sector. Some countries such as Brazil and Italy have already witnessed price corrections over the last five years with bank lending having slumped.
To the positive, bank capital and leverage ratios are about double the levels of a decade ago, offering more scope to absorb losses, and banks are generally less exposed to CRE.
In some cases, lending has moved over to non-banks, including up to 25% in some Europe and Asia markets. However, losses could be destabilising for particularly exposed individual banks or groups of banks. In the US, CRE loans are up to 40% of the loans at small banks, much higher than the average, and some 10 to 15% of banks are deemed highly exposed to CRE. During the GFC, 6% of highly exposed banks failed.
Slater noted that banks still have only $5 to $6 of capital for every $100 of assets.
Long-term CRE threats
Slater said currently, hotels are running at very low occupancy rates, retail units have seen sharp declines in customer footfall, and many offices are closed or running with very low staffing levels.
“In these circumstances, rental income and debt repayments from affected sectors are in grave doubt. But more worrying still is the longer-term impact. It’s possible that demand for office, retail and hotel space, and even urban multifamily housing may never recover to pre-crisis levels, leading to chronic oversupply, depressed rents, and defaults.”
Looking to past examples, price drops could extend much further. Past recessions in the US and UK have seen 20 to 30%, while Hong Kong prices were slashed in half in the late 1990s. US data to September shows double-digit declines in 2020, and prices of CRE funds in several economies point to similar drops.
