Commercial property outlook uncertain: RBA

Bad loans in the commercial property sector are a greater threat to financial institutions than mortgage stress and the outlook for the sector remains uncertain, a new Reserve Bank of Australia paper argues.

The message comes as another property expert says the commercial market will continue to struggle this year as secondary markets trail behind recovery in primary developments, such as office buildings and shopping centres.

Reserve Bank of Australia financial stability head Luci Ellis and department colleague Chris Naughtin, suggest the US mortgage crisis was exacerbated by problems in the commercial property market.

The paper notes that CRE loans are more concentrated in construction loans than housing lending. Imbalances can build, the pair argues, because construction lags last longer, and borrowers in CRE markets don’t have the same disincentives to default compared to residential buyers.

“Developments in housing markets are also important for financial stability, but banks’ related loan losses have historically been more concentrated in loans to (corporate) property developers, which are captured in CRE lending, than in loans to households.”

While this is true of the Australian market, the paper suggests the US mortgage crisis may have had more to do with commercial property than otherwise thought.

“Among US institutions insured by the Federal Deposit Insurance Corporation (FDIC), for example, C&D accounts for around 20% of CRE loans, compared with 3% for residential real estate.”

“This mix matters because C&D loans are inherently more prone to becoming impaired in a downturn than (secured) loans for buy-and-hold investment.”

Ellis writes that small US deposit-taking institutions are exposed quite highly to losses in the commercial sector. Commercial property lending accounts for 40% of their on-balance sheet gross loans, compared to 21% for mid-sized banks and 13% for large banks.

This exposure, she says, meant the subprime crisis was not entirely due to residential lending. Financial institutions were also impacted by problems in commercial property, where over 40% of commercial real estate loans were placed in small assets classed under $US10 billion.

“Similarly in Australia, much of the increase in exposures and non-performing commercial property loans has been seen among the smaller and foreign-owned banks,” she writes.

Ellis says commercial property recoveries tend to be longer than in residential markets due to the volatile nature of planning and construction. As a result, an Australian recovery may not be seen for some time.

“Vacancy rates tend to remain high long after the economic downturn and well into the subsequent recovery, because it takes a considerable period of time for excess supply to be absorbed,” she said.

“In the recession of 2000–2001, US office vacancy rates increased steadily from 7.7% in the September quarter 2000 to a peak of 16.8% three years later, and remained above 16% until late 2004, long after the turnaround in GDP growth.”

The RBA expects vacancy rates in Australia to reach 8.7% this year, and will remain steady in 2011. However, in the United States, office vacancy rates will still remain at 17.3% this year, and will increase to 17.4% in 2011.

“The outlook for commercial property markets and lenders in the major countries remains challenging as vacancy rates continue to rise and prices and rents are yet to recover,” the RBA paper states.

However, there is some good news. Ellis says loan losses in Australia due to commercial property have been “relatively small” compared to those in the US and in Europe.

While Australia recorded a commercial property price drop of 24.7%, Ireland recorded a 56.3% drop, while the US and Britain recorded falls of 44.2% and 43.7% respectively.

David Green-Morgan, research director at DTZ Research, says Australia has recovered fairly well compared to overseas markets.

“Different countries are at different stages of recovery, and because they all have different levels of debt in commercial property they’re going to have to deal with it in different ways. We have started to see a recovery in values, though.”

Green-Morgan says buildings in the primary sector, such as CBD offices and shopping centres, have continued to recover well. The real problem is smaller commercial properties.

“It’s going to be a struggle to find a huge number of buyers for many secondary properties, and when you only have a few different buyers then it obviously gets much harder to get the price that you want.”

He says that while the downturn was expected, there will not be a sustained recovery in the commercial property market until a solid macroeconomic recovery is underway. This could take several months.

“Until we see a sustained recovery both in the economy and overseas, those secondary assets are still going to be recovering.”