The Rise and Fall of Default

The default rate for commercial real estate mortgages held by the nation’s depository institutions–including mortgages at least 90 days delinquent and mortgages in non-accrual status–increased to 4.36 percent in the third quarter of 2010, up from 4.27 at midyear.

While the default rate continues to trend higher, the most recent increase is the second smallest in three years. Growth in the balance of defaults at banks has slowed considerably in recent quarters, according to Real Capital Analytics’ analysis of bank filings. The $604 million increase in the default balance in the third quarter is less than one-tenth of the $7.2 billion increase in the second quarter of 2007.

As property prices and rent measures stabilize in many markets, the increase in strain on bank health related to commercial real estate is also becoming more measured.


Reasons for Caution

The third quarter’s 9-basis-point rise in the commercial mortgage default rate is the 17th consecutive quarterly increase. At the low point in defaults, in the first and second quarters of 2006, the default rate was just 0.58 percent. By comparison, the current default rate is just 19 basis points shy of its record high of 4.55 percent, reported in 1992.

As banks have worked through only a subset of these loans–there are $46.8 billion in bank-held defaulted commercial mortgages as of the third quarter–the potential for losses related to resolutions of distress remains a key feature of the marketplace.


Multifamily Default Rate Rises

The multifamily default rate increased sharply between the second and third quarters, jumping from 4.13 percent to 4.67 percent. Between the first and second quarter, the multifamily default rate had fallen by 50 basis points, the first such decline of the cycle, raising hopes that the bank stress related to real estate exposures might have reached its inflexion point.

Over the course of the downturn, the increase in the default rate for multifamily mortgages has been more dramatic than for commercial real estate. The current multifamily default rate is nearly 20 times higher than the 0.24 percent default rate measured in the first and second quarters of 2005. Banks’ exposure to the multifamily sector is more limited, however, with total outstanding balances of $215.8 billion and mortgages in default of $10.1 billion.


Legacy Issues Constrain Bank Lending

The weight of unresolved distress is manifest in greater regulatory and supervisory oversight in making new loans, as well as adjustments in lending standards and many banks’ willingness to extend new credit in the sector. Demand for loans has also moderated.

As a result of these shifts, banks have been drawing down their exposure to commercial real estate, making new loans at a slower pace than the pace at which maturities, amortization and distress have removed exposure from their balance sheets. In the third quarter, total commercial real estate mortgage balances fell by $8.8 billion. In 2010 year-to-date, balances have fallen by $18.5 billion. Multifamily balances increased slightly from the second to third quarter but also remain below their peak levels from last year.


Smaller Banks Exhibit Lower Default Rates

Default rates are highest at the largest institutions (those with $10 billion or more in assets), where the concentrations in commercial real estate are lowest and the capacity to absorb related losses benefits from diversification. At smaller institutions (those with less than $1 billion in assets), default rates are generally lower. For example, at banks with between $100 million and $1 billion in assets, the commercial mortgage default rate is 3.29 percent, 107 basis points lower than the national average. But concentrations in commercial real estate, multifamily lending and construction lending remain much higher at these smaller institutions.

Combined with the lagging recovery in values in secondary and tertiary markets, where these banks dominate lending activity, the greater concentration still implies a much more limited capacity to manage related losses. It is important to note that there is considerable variation in the default and loss experience of regional banks, in particular. Institutions of similar size and geographic footprints and with similar exposures to commercial real estate exhibit differences in losses that may relate to the effectiveness of workout strategies and not just the health of the underlying mortgages.


Implications for Credit Availability

As reported by Real Capital, increases in the lending activities of large institutional lenders, including life companies, have resulted in an improvement in credit availability in many of the largest and most liquid metropolitan areas and for the highest-quality properties. This trend will see further support from an increase in securitization activity.

But outside of the major metros–including New York, Washington, D.C., and San Francisco, among a select few others–transaction activity and credit remain constrained. The slowdown in bank-held commercial mortgage defaults suggests that the sector’s contribution to bank distress may be nearing a plateau.

Nonetheless, banks still face serious challenges in drawing down their default and real-estate-owned balances and in working toward a normalization of credit in the markets where the bank-lending model is most appropriate.


Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.

The Rise and Fall of Default