Is Your Bank's Balance Sheet Overloaded With Distressed Real Estate?

Updated December 11, 2020
posted on 06-10-2019

Almost all banks own some real estate.

In the banking world, "real estate" refers to property that a bank owns in addition to its offices and branches. It's sometimes called by its official balance-sheet term, "Other Real Estate Owned," which has the nifty acronym OREO. These properties come from foreclosed mortgages or from collateral seized after a loan went bad. They can be single-family homes, commercial land or buildings, agricultural acreage or multifamily apartment houses -- anything with value and a title bearing a legal description in the county clerk's office.

While an Oreo on a plate is a nice treat, OREO on the balance sheet is a nasty problem. That's because banks aren't in the real estate business. They don't know anything about it. They're not property managers or brokers. Their job is to borrow money at a low rate and lend it out at a higher rate. The only reason banks should be in the real estate market at all is to make real estate loans. Yet even in good times, loans are going to go bad and the net result is that banks are going to wind up with property on the books. In bad times like these, though, more and more loans go bad and more property is seized. To make matters worse, a soft economy tends to depress prices, and in many cases a piece of property that's carried on the books at $100,000 might actually be worth only a fraction of that.

What's the effect? Well, assets are finite, so banking is a zero-sum game. If a bank has some of its holdings tied up in properties, it can't put those dollars to work by making loans. Loans, of course, generate interest income for the bank. Real estate generates cost: After all, properties have to be maintained and repaired. Taxes have to be paid; insurance policies put in force and premiums remitted. The effect, then, is that owning a bunch of real estate erodes a bank's net interest margin.

Banks make some money from fees from financial services, but they bring in most of their revenue from loans. But the money that they lend out also has a cost, such as the interest the bank had to pay customers to entice them to deposit their cash in the first place.

Let's keep the math simple and say that a given bank has interest income on all its assets of 5% and a cost of 3%. The bank gets to keep the spread, or 2%, less costs, for itself.  So a bank with a $500 million loan portfolio has the following (extremely simplified) income statement:

But let's see what happens if a bank has an appreciable amount of real estate -- say 10% of assets -- on its books. Now instead of earning that 5% on its entire portfolio, it's only earning 5% on $450 million. And the odds are that it's still costing the bank at least 5% of the value of the asset to maintain it, insure it and pay the taxes on it. So while income will go down, costs will remain the same (and may well be higher). So the picture now would look like this:

Now, $7.5 million still might seem like a lot of money, but the bank has to use those funds to pay all its salaries and employee expenses, as well as to take care of its branches, keep the lights and phones on and the computers running. It also has to set aside funds to cover bad lending decisions, which right now, according to federal data, are equal to 2.64% of all loans. (That's a more than fivefold increase from 0.50% just three years ago.)

The drain from real estate -- which, unfortunately, usually accompanies an increase in past-due loans, which also lessen interest income while not reducing cost -- can very easily push a profitable bank into the red. In fact, the one-two punch can do more than just result in a few lackluster quarters or diminished dividends, it can lead to bank failures. That's happening. The FDIC has more than 800 banks on its "Troubled Bank" list, a number that in normal years is well under 100. Bank failures, which did not end in the Great Depression, are more than 20 times higher right now than they are in typical years, and that trend is likely to stay with us as banks try to work their way through hundreds of millions of dollars worth of problem loans. 

There is not a banker anywhere in the United States, and I mean not a single one, who would ever choose to seize collateral or foreclose on a mortgage if he could avoid it. Bankers hate to pay lawyers and they hate even more to weigh down their balance sheets with property. No bank wants to own real estate, it's just a cost of doing business. These days, it's a bigger cost than banks would like. Right now, the average bank has 0.37% of its assets wrapped up in real estate. In good times -- say, three years ago -- that number should be somewhere around 0.06%, or less than a sixth of what it is today. All told, banks have $49.4 billion in real estate on their books. That's enough to buy a home at the U.S. median price for every household in a city like Charlotte, North Carolina (home to roughly one million people).

While 0.37% is the average amount of bank assets allocated to real estate right now, it's not at all difficult to find banks with 10 or even 20 times that amount of OREO on their balance sheets.