by Calculated Risk on 12/06/2006 06:20:00 PM

Steven Pearlstein writes in the WaPo: An Economic Pillar on the Verge of Collapse

... enough hand-wringing over the residential real-estate market. Not much anyone can do about that now. The new story is the bubble in the commercial real estate market -- offices, hotels and retail establishments -- which has generated spectacular returns for investors over the past few years.

Prices have risen to ridiculous levels, relative to the risk involved and the amount of income generated by these properties. But even those prices don't seem to scare away ... investors, who continue to pour hundreds of billions of dollars into real estate investment trusts, private-equity real estate funds and hedge funds that specialize in real estate finance.
...
What, exactly, does that mean?

First of all, it means that the lessons of the past five real estate crashes have, once again, been forgotten, and real estate has once again become a highly leveraged investment class.

From the FDIC report last month: Economic Conditions and Emerging Risks in Banking

Small and mid-size institutions have been increasing their concentrations in riskier assets, such as CRE loans and construction and development (C&D) loans. This suggests that, although small and mid-size institutions have been more successful in limiting the erosion of their nominal NIMs, they have achieved this success in part by assuming higher levels of credit risk.

... continued increases in concentrations and reports of loosened underwriting standards at FDIC-insured institutions signal the potential for future credit quality deterioration. In addition, regulators have noted increasing C&D and overall CRE loan
concentrations, especially at institutions with total assets between $1 billion and $10 billion. Four of six Regional Risk Committees expressed some level of concern about CRE lending, in part due to continuing increases in concentrations.

And today from the FDIC, OCC and the Fed: Federal Banking Agencies Issue Final Guidance On Concentrations in Commercial Real Estate Lending

The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation on Wednesday issued final guidance on sound risk management practices for concentrations in commercial real estate lending. The guidance is intended to help ensure that institutions pursuing a significant commercial real estate lending strategy remain healthy and profitable while continuing to serve the credit needs of their communities.

The agencies have observed that commercial real estate is an area in which some banks are becoming increasingly concentrated. This trend is particularly evident among small-to medium-sized banks that are facing strong competition in other business lines. The agencies support banks serving a vital role in their communities by supplying credit for business and real estate development. However, the agencies are concerned that rising commercial real estate loan concentrations may expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in commercial real estate markets.

Back to Pearlstein:

... at some point this commercial real estate bubble will burst.... I can't tell you exactly how it will unfold, or when. But when it does ... everyone will look back and wonder why anyone could have doubted there was a bubble, why credit-rating agencies didn't warn of the risks, and why bank and securities regulators didn't step in.

Well I guess bank regulators are expressing some concern on CRE (see new guidance). I think it is more difficult to call CRE a "bubble", as compared to the residential housing market, but the impact of a shakeout could be significant with the extensive leverage of buyers, and the loan concentration of mid-size institutions in CRE.