Why Do Weak Bank Loan Portfolios Drive Down Real Estate Prices?

Banks are in the business of making loans where they receive repayment of principal AND interest. ??

Banks are not in the business of being equity investors; hence there is a significant focus on the quality of loans which banks originate.?

The higher the quality of the borrower who receives a loan from the bank, the higher the likelihood of full repayment of the loan.?

Everyone is happy.?

Not all banks or lending institutions have the same criteria for selecting borrowers who will receive loans.?

Across the broad spectrum of banks and lenders, some focus on originating certain types of loans: new construction lending, automobile lending, credit card lending, home purchase lending, commercial and institutional lending, receivables lending, etc.?

Different types of lending are typically associated with different quality of borrowers AND even within the same category of lending, there can be high quality borrowers and low quality borrowers.?

Given that small banks today hold a significantly higher concentration of commercial real estate loans totaling $1.9 Trillion compared to $1.0 Trillion in 2017, those professional forecasters and informed investors are keenly watching the financial health of banks for signs of weakening and distress.?

Many consider the cockroach theory of banking to be in play, namely, where there are a few failures, there could be many more.? Just earlier this year, the 2 biggest bank failures in history occurred that shocked the market.

As noted in the graphic below from Forbes, there were 297 failures in 2009 and 2010 during the global financial crisis (GFC) and massive quantities of loans (also known as bank assets) were affected.

Therefore, as many banks have generally experienced good times over the recent years, they are significantly less prepared to handle a rapid increase in non-performing loans.?

A rapid increase in borrowers who are not repaying their loans forces banks to quickly set aside their precious capital to brace for increasing distress or outright default on the loan.?

With banks decreased capacity to absorb? increases in loan defaults by their borrowers, banks are not capable of making new loans because their precious bank capital is sequestered for covering potential loan losses.?

Therefore as loan delinquencies increase, banks are not only troubled by borrowers who are not paying their loans (aka no revenue to the bank), the banks are troubled by an inability to make good loans because their capital is no longer available for lending.?

As banks precious capital is no longer available for lending, banks tend to increase their interest rates on loans they will originate and they require more equity from their borrowers.?

Both of these actions have negative impacts on borrowers desire to borrow and ability to borrow.?

When a commercial borrower has to contribute 30% equity to secure a loan instead of 20% equity, that equates to a 50% increase, AND the borrower is regularly going to be paying a higher interest rate on the 70% loan they receive.

Now the borrower has to pay higher interest expense and the net income remaining after all expenses and debt service is measured against a larger equity component that translates into a significantly lower return on invested capital.

Simply stated, as borrowing costs go up and equity requirements for bank loans increase, buyers of real estate (or buyers of any asset for that matter) have to pay a lower purchase price to generate an acceptable return.?

Hence, during difficult financial times, sellers are painfully reminded that they are at the mercy of what buyer’s are able and willing to pay.

And then there is the painful wildcard for many borrowers.?

That wildcard is mandatory repricing of their loans every 5 to 10 years.?

More on this topic in the next article discussing the potential rise in unexpected sellers.