When a commercial bank issues a loan they will ensure the ratio of NOI to loan payments is something like 1.25:1 so if the rental property earns $100,000/yr then they'll only issue a maximum amount of debt such that the loan payments are $80,000/yr.
They might enter into a 25 years amortization for the loan but a 5 years term. After covid and many "work-from-home" initiatives, many renters left commercial properties and NOI went down while interest rates also went up. When terms matured, oftentimes the ratio dropped from 1.25 to 1.00 or even worse. If the ratio is 0.50 in theory, the business shouldn't be able to repay its debt and banks in theory should call the loan or find a way to secure enough income somehow to cover the loan payments (corporate guarantees from other businesses, etc...) or they restructure (demand cash payments to paydown debt to reduce the total exposure etc...). Many banks did not restructure the debt or secure some sort of income source to ensure a 1.25:1 ratio but the debt was still being repaid. Oftentimes, this debt was simply being repaid by a line of credit or something. In effect, the banks are just kicking the can down the road. At some point, it'll become unsustainable and the eventually the person will default on their loan. Of course, that's assuming renters don't come back and/or the borrower doesn't secure more income somehow. Banks kicked the can down the road because real estate prices were so bad, the banks didn't want to take ownership of the real estate by calling the loan. The hope from banks is that lower interest rates will help bring the ratios back to >1 or at the very least increase real estate values enough that assuming the debt becomes worthwhile. Of course what could also happens is that the lower rates don't help enough and then a whole bunch of commercial banks start taking huge losses on commercial real estate.
I actually do lending in commercial real estate and my assessment from the inside is that there is a worry and it's quite noticeable my FI is quite worried about these issues but so far everything seems to be trending in the bank's favor. I believe most commercial banks will unwind their positions and no big giant systemic event in commercial real estate losses will get triggered. The biggest issue though is like the article says. By simply renewing all these loans that weren't very good instead of calling them or restructuring properly, it actually did make it much harder to originate new loans and that has taken a hit to our profitability. Still, it might have been the right move in the end.
I'm suspicious that most of the Commercial Real Estate market is now dead at this point, given how cheaply built even new buildings are, even though they are extreme in their cost, most of the businesses that were bought during Covid haven't come back, and the economy isn't improving. It's becoming a situation where I'm wondering why anyone would want commercial property.
Banks kicked the can down the road because real estate prices were so bad, the banks didn't want to take ownership of the real estate by calling the loan.
This whole economy is a shell game mixed with musical chairs. Like, musical chairs where if you sit on the wrong chair, it detonates C4 and kills everyone in the room. The music stopped several times, and so everyone just keeps walking in circles and singing pretending that the music is still going, hoping no one has to actually sit on anything.
The trouble is that who will buy commercial real estate? You can't just convert a commercial building into apartments. There's a whole lot of red tape and utility modification etc to do. It can be done but it's not simple or easy.
I've always assumed this was a large driver of the "return to the office" trend that is starting.
I suspect the federal/state governments will buy the properties as they can always fill them with migrants.
Here's what's actually going on.
When a commercial bank issues a loan they will ensure the ratio of NOI to loan payments is something like 1.25:1 so if the rental property earns $100,000/yr then they'll only issue a maximum amount of debt such that the loan payments are $80,000/yr.
They might enter into a 25 years amortization for the loan but a 5 years term. After covid and many "work-from-home" initiatives, many renters left commercial properties and NOI went down while interest rates also went up. When terms matured, oftentimes the ratio dropped from 1.25 to 1.00 or even worse. If the ratio is 0.50 in theory, the business shouldn't be able to repay its debt and banks in theory should call the loan or find a way to secure enough income somehow to cover the loan payments (corporate guarantees from other businesses, etc...) or they restructure (demand cash payments to paydown debt to reduce the total exposure etc...). Many banks did not restructure the debt or secure some sort of income source to ensure a 1.25:1 ratio but the debt was still being repaid. Oftentimes, this debt was simply being repaid by a line of credit or something. In effect, the banks are just kicking the can down the road. At some point, it'll become unsustainable and the eventually the person will default on their loan. Of course, that's assuming renters don't come back and/or the borrower doesn't secure more income somehow. Banks kicked the can down the road because real estate prices were so bad, the banks didn't want to take ownership of the real estate by calling the loan. The hope from banks is that lower interest rates will help bring the ratios back to >1 or at the very least increase real estate values enough that assuming the debt becomes worthwhile. Of course what could also happens is that the lower rates don't help enough and then a whole bunch of commercial banks start taking huge losses on commercial real estate.
I actually do lending in commercial real estate and my assessment from the inside is that there is a worry and it's quite noticeable my FI is quite worried about these issues but so far everything seems to be trending in the bank's favor. I believe most commercial banks will unwind their positions and no big giant systemic event in commercial real estate losses will get triggered. The biggest issue though is like the article says. By simply renewing all these loans that weren't very good instead of calling them or restructuring properly, it actually did make it much harder to originate new loans and that has taken a hit to our profitability. Still, it might have been the right move in the end.
I'm suspicious that most of the Commercial Real Estate market is now dead at this point, given how cheaply built even new buildings are, even though they are extreme in their cost, most of the businesses that were bought during Covid haven't come back, and the economy isn't improving. It's becoming a situation where I'm wondering why anyone would want commercial property.
This whole economy is a shell game mixed with musical chairs. Like, musical chairs where if you sit on the wrong chair, it detonates C4 and kills everyone in the room. The music stopped several times, and so everyone just keeps walking in circles and singing pretending that the music is still going, hoping no one has to actually sit on anything.
NOI = Net operating income
Amortization = repayments on a set schedule
FI = Fucked Ifiknow??
The trouble is that who will buy commercial real estate? You can't just convert a commercial building into apartments. There's a whole lot of red tape and utility modification etc to do. It can be done but it's not simple or easy.
I've always assumed this was a large driver of the "return to the office" trend that is starting.
I suspect the federal/state governments will buy the properties as they can always fill them with migrants.
Financial Institution, I assume.