Banks may have to brace for heavy losses as commercial property prices plunge

KEY POINTS
  • In previous downturns, commercial property loan losses were “heavy” and there are worrying signs that such a trend could be repeated this time during the pandemic-induced slowdown, Oxford Economics’ Adam Slater said in a report.
  • During the 2008 great financial crisis, for example, such loan losses accounted for between 25% and 30% of total loan write-offs in the U.S.
  • “Large (commercial real estate) price declines generally translate into big losses for banks,” Slater, an economist at the firm, wrote.
  • This time those risks look highest in the U.S., Australia, and parts of Asia such as Hong Kong and South Korea.
Rear view of woman looking towards downtown area of Hong Kong.
 
(Photo: Getty Images | d3sign)

SINGAPORE — Commercial real estate prices have plunged this year as people stopped going into offices, and retail businesses were disrupted. That could lead to a significant amount of losses for banks, according to a recent report.

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In previous downturns, commercial property loan losses were “heavy” and there are worrying signs that such a trend could be repeated this time during the coronavirus-induced slowdown, Oxford Economics’ Adam Slater said in a report.

In a worst-case scenario, Slater said these loan losses would “materially erode” bank capital.
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“Large (commercial real estate) price declines generally translate into big losses for banks. Write-offs of (commercial real estate) loans made a big contribution to overall bank losses in the last two major downturns,” wrote Slater, an economist at the firm.

During the 2008 great financial crisis, for example, such loan losses accounted for between 25% and 30% of total loan write-offs in the U.S.

This time those risks look highest in the U.S., Australia, and parts of Asia such as Hong Kong and South Korea. In these economies, lending growth has been high, with “significant” loan exposure. But commercial property prices are already sliding, especially in Hong Kong, the report said.

In Singapore, office rents had their steepest decline in 11 years in the third quarter, official data showed on Friday. Rents for office space fell 4.5% in the latest quarter till September.

The firm’s index of global commercial real estate prices based on seven large markets show they are down 6% from last year.

“Could the coronavirus crisis lead, via the commercial property sector, to long-term problems for the banking and financial systems? … we think it is a genuine concern,” Slater wrote.

 
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“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,” he said. “In these circumstances, rental income and debt repayments from affected sectors are in grave doubt.”

Oxford Economics analyzed 13 major economies and found that write-offs of 5% of loans would amount to the equivalent of a loss between 1% and 10% of banks’ tier 1 capital, their primary funding source including equity and earnings. The biggest impact would be felt in Asia, it said.

Bond investors may also be at risk.

In the U.S., around half of the lending by this sector is not made through bank loans, and that includes the issuance of bonds in the sector, according to the report. In parts of Europe and Asia, that proportion of borrowing through the non-bank sector has risen to 25% or more, in recent years.

“In the case of property funds, (commercial real estate) downturns could see a rush by investors to redeem their holdings leading to fire sales of assets — amplifying price declines and broader loan losses,” said Slater.

But there’s one bright spot. Banks are in better shape to absorb them as compared to a decade ago. Their capital and leverage ratios are around double the levels a decade ago, Slater said.

Following the financial crisis, reforms were introduced to mitigate risk and improve the resilience of the global banking sector, by maintaining a certain leverage ratios and levels of reserve capital.

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