Commercial Real Estate Loans A Growing Problem For Banks
IBD
Norm Alster – Mon Nov 2, 6:47 pm ET
Housing may be starting to turn the corner. But commercial real estate's woes may be just beginning.
Banks' loan quality "continues to deteriorate," in large part due to commercial real estate, said Jon Greenlee, associate director of the Federal Reserve's banking supervision and regulation division, before a House panel.
Over the next 15 months, $2 trillion worth of commercial mortgages will mature, notes Jeffrey Rogers, president of Manhattan-based Integra Realty Resources, appraisers of commercial real estate. With office vacancy rates soaring, rents deflating and property values still falling, lenders face rising default rates likely to trigger new write-offs. Many banks have yet to bite the bullet and address the problem.
In all, banks stand to lose $200 billion to $300 billion on commercial real estate loans, estimates Richard Parkus, head of commercial real estate debt research at Deutsche Bank Securities.
In an Oct. 28 report that has attracted the attention of several government agencies, Parkus predicted that "many hundreds" of banks will fail due to their exposure to commercial real estate.
On Friday, billionaire Wilbur Ross lent his voice to those predicting a "huge crash in commercial real estate," Bloomberg reported. Fellow megainvestor George Soros predicted a "bloodletting."
Lenders are learning that many commercial property owners can't pay back loans -- or qualify for new ones. Delinquency rates on construction loans have already soared to 16% and could go much higher, notes Parkus.
And yet to this point, he adds, the banks have taken very little in charge-offs or reserves for commercial real estate losses.
"Less than 1% of commercial real estate loans have been written off. Our expectation is that losses will exceed 8%," Parkus told IBD.
And despite the 16% delinquency rate, banks have written off just 4% to 7% of construction loans, he estimates.
"It looks like most of the reckoning lies ahead," he said.
Rogers reasons that banks have lagged in taking charges because they haven't had to. Accounting rules now give them wide latitude in recognizing impaired loans.
"They have not been forced to mark to market," he noted.
The immediate source of trouble for borrowers is no mystery: Massive job cuts have slashed office occupancy and crimped consumer spending in retail outlets. By year-end, 2.5 million office jobs will have been lost, says Matt Anderson, partner with Foresight Analytics, a real estate research and forecasting firm in Oakland, Calif.
Suburban office vacancy rates across the U.S. will approach 20% by the end of the year, Anderson reports. Rents have fallen by 17%.
In Manhattan, notes Parkus, office rents have fallen by roughly 50% from their peak. He expects further declines.
Summing up the problem, Rogers said, "Commercial real estate properties are not generating enough cash flow to pay off mortgages."
There are ways that the banks can delay their day of write-down reckoning. One option is to offer refinancing on a maturing loan. But this is often not possible because the borrowers, with depreciated property assets, don't qualify.
'Extend And Pretend'
More typically, the banks extend loan repayment terms, pushing the crisis further into the future.
"The saying is: 'extend and pretend. Pretend that things are getting better,'" said Jonathan Simon, president of Simon Development Group, which owns office, retail and residential property in New York City.
But "extend and pretend" is just a band-aid.
"It doesn't solve the problem," said Anderson. Extending deadlines for balloon payments just swells banks' backlog of bad debt maturing in coming years.
If the banks do allocate new reserves in anticipation of write-offs, they would face renewed pressures to raise capital. And their ability to make new loans would also be curtailed. "They're not going to have the money to lend to entrepreneurs and families," said Rogers.
The FDIC last Friday issued guidelines that encourage banks to do "prudent" loan modifications with "credit-worthy" borrowers. It would appear that the FDIC hopes to at least partially stem the advancing tide of defaults with loan rewrites.
Big banks, including Bank of America (NYSE:BAC - News), Citi (NYSE:C - News) and Wells Fargo (NYSE:WFC - News), have significant commercial loan exposure. In some cases, the exposure is via commercial-mortgage-based securities held off-balance sheet.
"Some lenders originated mortgages, packaged them and sold them off as CMBS. But they'd keep some in off-balance-sheet vehicles," said Anderson.
It is near impossible to know just how much exposure banks have to commercial real estate in these off-balance-sheet entities, he said.
Regional Fallout
Still, the large banks have been less exposed to commercial real estate loans relative to their smaller peers.
The Fed's Greenlee warned of "unprecedented concentrations of CRE loans" at some regional and community banks.
Scott Valentin, regional bank analyst with FBR Capital Markets, has computed commercial loans as a share of total outstanding loans as of June 30 at various banks.
Thirty-nine percent of M&T Bank Corp.'s (NYSE:MTB - News) loan portfolio is commercial real estate, according to Valentin. Regions Financial's (NYSE:RF - News) share is 36% vs. 35% at BB&T (NYSE:BBT - News), 34% at Comerica (NYSE:CMA - News), 25% at KeyCorp (NYSE:KEY - News) and 23% at Fifth Third (NasdaqGS:FITB - News).
Most regionals have yet to charge off the bulk of souring debt. "A very small fraction of eventual commercial mortgage loan losses have been reserved or charged off to date," said Valentin.
Manageable Or A Massacre?
Some real estate observers contend that the problems are manageable. Dan Fasulo, managing director of Real Capital Analytics in New York City, says lender losses could be contained to the "tens of billions." Pain from defaults "will be spread around," he reasoned. "I don't see a situation where commercial real estate will impact the overall health of the financial system."
But Anderson believes commercial real estate could bring down 650 banks in addition to the more than 100 that have already failed. "There's more of the trouble ahead of us than behind us," he said.
As with residential mortgages, loose lending played a large role in setting the stage for the looming commercial crisis. Loan volume soared during the 2001-2007 period as the Fed kept rates low and lenders made cheap money available on easy terms. Loans were often made on inflated property valuation and cash-flow assumptions.
And lenders were willing to get "creative." Traditionally, commercial loans amortized interest and principal over 20 years or more. But recent loans were designed to lure buyers with seemingly cushy terms. Only interest was paid back for the first few years. But a balloon payment of principal would suddenly come due after three to seven years, notes Anderson. Those balloon payments are now coming due.
At highest risk are loans done in 2006 and 2007, says Anderson. These were based on hyper-inflated property values and Anderson questions if they can be refinanced now that values have tumbled. Just over $50 billion of the 2006-07 loans mature this year and next. But the real flood of maturities follows closely behind. From 2011 to 2013, $300 billion of these loans, many already problematic, are due for full repayment, Anderson estimates.
With the economy reviving in Q3, commercial real estate sales also picked up, noted Real Capital Analytics. The property research firm also said the value of distressed properties rose just 1% in September, while increased asset resolutions and foreclosures offer "some hope that lenders are becoming more proactive" at dealing with their CRE woes.
But problems continue to mount. CMBS delinquencies rose to 4.8% in October from 4.36% in September and just 0.77% a year earlier, according to Trepp LLC, which analyzes commercial real estate finance.
"We're probably in the second or third inning of real estate problems. It's just starting," said Valentin.
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