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Monday, June 21, 2010

Op-ed on RBA analysis of commercial property risk (for investors)

Echoing my previous statements on this subject, the RBA has just published an outstanding paper that shows commercial real estate has both historically, and in the recent crisis, proven to be significantly more risky for creditors, investors and the financial system at large than housing.

This is an important finding. Millions of hectares of forest are dedicated to discussing housing market risks. But comparatively little attention is directed at understanding commercial real estate, which, in the RBA’s opinion, is actually of greater concern for policymakers and regulators than residential real estate. This was certainly true for the Australian banking system during the GFC, which suffered much deeper losses in this area than its holdings of residential mortgages.

The public commercial property neglect is probably a function of a few factors.

First, commercial property is almost exclusively owned by powerful institutional investors. In comparison, Australia’s circa nine million dwellings are held by faceless families.

It is much easier and sexier for the media and economic commentators to spook mums and dads with headlines in the broadsheets. This is also borne out by media traffic—doomsday articles on housing consistently out-rate other topics.

This means that we tend to read much more about the risks that affect Australia’s 8.5 million households than the empirically more threatening hazards triggered by the commercial real estate investments to which a small number of institutions and banks are exposed.

Finally, whereas there are around half a million residential property sales recorded each year, commercial property transactions are few and far between. This illiquidity in turn makes accurately measuring commercial risk much harder than residential risk.

Commercial property indexes are based on subjective human assessments of value (investors are also paying valuers to price these assets, which raises conflicts of interest). House price indices, by way of contrast, do not use ‘appraisals’—they rely exclusively on market sales. As a result, commercial property indices tend to paint artificially rosy pictures of performance when the truth can be more disturbing. But if the value of housing is falling, you will see it pretty quickly in the indices.

One other reason for considering the RBA’s analysis is that roughly one-tenth of all our super fund money is invested in commercial property. It is, therefore, useful to get a handle on the risks associated with these investments.

In a paper published last week, Dr Luci and Chris Naughtin of the RBA arrive at one key, and arguably counter-intuitive, conclusion: “Commercial property and property development have historically posed a greater direct risk to financial institutions’ balance sheets than have housing and mortgage markets... Bank exposures to commercial real estate (CRE), along with other corporate lending, have historically been one of the main sources of loan losses during episodes of banking sector difficulties.” They attribute this to four factors:

1) Commercial property lending tends to be much more heavily concentrated in riskier credit for construction and development purposes than residential lending, which is focused on less risky ‘established’ housing;

2) Construction times in the commercial property sector are longer than residential development (a home can be erected more rapidly than a shopping-centre), which means investors are exposed to higher probabilities of loss if the cycle suddenly turns;

3) “[I]ncentives to avoid default are weaker for borrowers in the commercial property sector than they are for home loan borrowers”, which simply tells us that lenders are more likely to lose money; and

4) The nature of commercial property lending induces higher ‘correlations’ in defaults than residential credit (ie, there is a greater chance you will experience portfolio-wide losses).

The RBA’s analysis of both the GFC and previous crises draws it to the contrary-to-popular-myth determination that the commercial property sector is a more important driver of bank losses and system instability than housing markets. This conclusion is substantiated in a number of ways. The RBA begins by demonstrating that there have been wide differentials in the price falls experienced in the two markets:

“[D]uring the recent economic downturn the...decline in commercial property prices has been much greater than for residential property, even though the run-up in commercial property prices in some cases was much less marked [see Table 1 below].”

Next the RBA shows that new commercial property development has a more significant influence on the stock, or supply, of existing assets than housing construction. Think of the supply-side effects of a new skyscraper being built in the Melbourne CBD compared with a single residential project. The RBA argues that the lumpier nature of commercial construction generates far higher ‘cyclicality’ than one sees in the housing market, which is evident in the lagged and pro-cyclical relationship between commercial vacancy rates and economic activity: “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 [see also Table 2 below].”

The third dimension the RBA examines is default risk. The RBA finds that both the probability of default and the magnitude of losses are higher when lending against commercial property because: (1)“[d]efaults on CRE lending tend to be bunched in cyclical downswings, more so than defaults on residential mortgages”; and (2)“[o]wners of CRE are…more likely to default in a downturn than home-owning households, who derive the same real benefit from living in their home regardless of its price.” In contrast, commercial property owners are subject to loss of tenants and income, and “[i]f the value of the property has also fallen below the size of the loan, these borrowers might make themselves better off by defaulting.”

Here the RBA observes that home owners tend not to default even if they face the risk of their debts exceeding the value of their property: “Only a small minority of home mortgage borrowers in negative equity actually default, even in the US where lenders frequently do not pursue defaulters for any deficiency between the collateral value and the loan amount.”

The RBA goes on to present data on default rates and losses (known as “charge-offs”) for commercial and residential property loans in the US. They note that the higher default and loss rates on commercial lending are mainly driven by construction and development activities, which are represented by the orange line in the graph below.

Finally, the RBA argues that because commercial property loans are much shorter-term than 25 to 30 year amortising residential mortgages, they are characterised by commensurately greater risk: “CRE borrowers…face more refinancing risk than mortgage borrowers in most countries; when that risk does crystallise, it is generally correlated across borrowers as the credit cycle turns.”

Fascinatingly, the RBA hypothesises that the teaser rates offered on many US home loans prior to the GFC resulted in a new convergence between housing and commercial property credit risks. That is, unlike their peers in other housing markets, US borrowers began to confront unprecedented refinancing risks. This led the RBA to conclude, “[i]t is not a coincidence that mortgage defaults became more cyclical and more correlated following that shift – that is, more like the historical pattern of defaults on CRE loans.”

A senior Australian banker from one of the majors recently captured wide media attention by calling for APRA to adjust the capital treatment applied to commercial lending back in line with residential credit. He suggested that it was unfair that lending to housing was favoured over loans to business.

In parliamentary testimony, the Governor of the RBA rejected this on the basis that that commercial lending is much riskier than residential credit. Ellis and Naughtin’s paper presents the research to substantiate the Governor’s claims.

A secondary allegation made by banker in question was that lending to housing is unproductive. While I have addressed this myth at length here, it is worthwhile restating that in supplying accommodation for labour, housing is no different to commercial real estate that affords shelter for business.

In closing, I’d encourage readers to reflect on the RBA’s final words in full:

“In the current cycle as well as in previous ones, the downturn in commercial property and development markets has generally been more severe than in housing markets. The effect on bank loan losses is also generally greater…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.”