Wednesday, January 28, 2009

Why Does CRE Go So Bad So Fast?

CRE problems are escalating rapidly. There is a good CoStar article here discussing the trend. A chart from that story speaks volumes:


(Click on image for a larger version in a new window).

Why do problems escalate so quickly? I don’t have definitive answers, but I can offer three analogies which based on my experience have some validity.

The Blighted Crop Analogy. I grew up in farm country (eastern South Dakota). Crop farmers have really good years, ok years, and really bad years depending on what they planted and weather conditions. Here is a picture of what things look like in a really bad year:


Note this is not a mixture of corn plants doing well and doing poorly; every plant is suffering is a result of environmental conditions. So, under this analogy CRE deteriorates rapidly because the conditions which stress CRE stress all CRE projects. Severe employment loss, high interest rates, liquidity crunch limiting refinance options, etc. are all stressors which have played a part now and in the past. One of the profoundly stupid things you hear some people say is “XYZ lender is not taking enough risk, their loan delinquency rate was only X% last year.” That’s now how it works – you have no delinquencies for many years, and then conditions occur which cause your delinquency rate to skyrocket.

The Vintage Analogy. The is a strong correlation between CRE performance and Loire whites; 1991, 1992, and 2001 were bad years for both. A vintage table courtesy of Robert Parker:


Seriously, like wine, loans are made under conditions which vary over time. There are always a substantial contingent of borrowers who want the absolute maximum leverage a lender will give them, and the willingness of lenders to satisfy that demand goes up during good times. So, during times of peak rents and occupancy levels there are a lot of loans done using aggressive underwriting parameters, and when market conditions soften those loans all go upside down at once. I don’t know how good 2006 and 2007 Loire whites will be, but I am confident those will be bad origination years for CRE loans.

The Blood from a Turnip Analogy. There is a perception that CRE borrowers readily walk when their deals go upside down, because they are coldhearted businessmen constantly evaluating the economics of their deals (as opposed to warmhearted homeowners irrationally committed to their residences), and because their loans tend to be non-recourse. Here, for example, is a Calculated Risk post which takes this position.

In my experience, that isn’t how it goes. Undoubtedly some owners walk early, but in my experience most CRE borrowers feed their deals until they’re tapped out. I’ve written why I think that happens here. CRE owners tend to own multiple properties. As problems develop, they bleed the properties performing well to support the underperformers. This works for a while, but if difficult conditions persist the lack of reinvestment in the good properties drags them down too. None of the properties default, until they all do.

Individually, none of these analogies explains the entire phenomenon, but taken together I think they account for why CRE problems escalate so rapidly.