State of CRE Financing Part I: Beyond What Was Expected CoStar.com
Written by Mark Heschmeyer
Residential Depression -- Not CRE Market Conditions -- Is the Main Force Constraining "Commercial Real Estate Lending"
"Beyond what we expected." That was how U.S. banks portrayed the first quarter in regards to their real estate lending - and they weren't being positive.
The amount of residential asset writedowns, the amount of reserves they have needed to set aside and the spillover of residential downturn into commercial real estate are going beyond what they expected just late last year.
For clarification purposes, the vast majority of banks treat residential construction loans as commercial real estate lending because that is how such loans are categorized by federal banking regulators. What's clear is that the vast majority of writedowns, reappraisals and delinquencies in the asset portfolios of U.S. banks are tied to residential construction. And without exception, the outlook for that segment of their business is still dismal.
While the owner- and non-owner-occupied commercial building loans segment of their portfolios remain stable, the chain reaction effect from the housing market collapse is beginning to show signs of creeping into these assets, according to banks' first-quarter results.
And, partly because of all the intermingled nature of loans and different real estate types, the outlook for lenders, the U.S. economy and commercial real estate is - in bankers' words - hard to predict, but is clearly going to be less robust for the time being.
John Allison, chairman and CEO of BB&T Corp. in Baltimore, MD, summed it up residential and commercial markets best in his quarterly conference call: "We expect real estate markets to remain slow and for prices to continue to fall, maybe another 5% to 10%, but it will vary a lot by market. We do think real estate will bottom this fall and be recovering in spring of 2009. Real estate price cycles typically run three years and in the spring of 2009, it will be three years."
"I think we're two-thirds [of the way through] recognizing the non-performers and maybe two-thirds, or probably more like a half, [the way through] recognizing the losses because we really didn't turn into losses until the fall. If you look at prices, [they] peaked two years ago in the spring of 2006, but because we've been on such a long run, it was really [the last part of] 2007 before we started really turning into losses. This is just a wild guess, I'm guessing we're probably halfway through the loss process as an industry."
(Editor's Note: This is the first of a two-part story examining the state of commercial real estate finance. CoStar Advisor has reviewed the first quarter results of more than 75 bank and bank holding companies, read through more than a 300,000 words in earnings call transcripts (the equivalent of more than 225 CoStar Advisor news stories) and culled through several federal regulatory surveys and banking reports. Part I looks at the current state of commercial real estate markets from the lenders' viewpoint. Part II of the story to be published next week looks at how lenders are and will be responding to market conditions and their outlooks for the coming year.)
It All Starts with Housing
To understand current commercial real estate market conditions, the housing market deflation cannot be ignored. It all started with the unexpected rapid implosion of the subprime mortgage market in February of last year. That was the event that wiped out an entire support base on which housing sales were based: the first-time and low-income homebuyer.
When that support cracked, so did a second column of support: the speculative investor that hoped to flip a property in a year or two. Then the whole housing market came tumbling down.
It triggered an immediate drop in value of hundreds of billions of dollars of mortgage-backed securities, which triggered the substantial write-off in values of assets at financial houses, closed the spigot on the issuance of new mortgage-backed securities and eventually shut down additional real estate lending. It was the proverbial house of cards collapse.
The chain reaction effect is important to understand because it explains in a lot of ways why banks, lenders and Wall Street have so far seemed to be caught off guard.
"The real problem today is what's happening 'around' our loans not so much what's happening 'with' our loans," said George L. Engelke, Jr., chairman and CEO of Astoria Financial Corp.
If you've got a community that's got 50 houses for sale and they are all in foreclosures or financial trouble, Engelke noted, "People can't get a transaction done."
No matter how well banks monitored the individual loans in their portfolio or the performance of their customers, it was not enough to see how they would be impacted from the chain reaction. Likewise, no matter how good customers' credit condition looks on paper, it is still hard to get a loan.
Because of that, it is not unusual now to see banks writing down the value of loans that they normally would not have and not making loans that normally would have. Bryan Jordan, CFO of First Horizon National Corp. gave this account of one loan that was current and in good standing.
"We observed the draw inactivity on construction projects in California City [in Kern County east of Bakersfield, CA]," Jordan said. "Our investigation identified that the local city had placed a stock order on construction by this customer due to past due real estate pattern and additional lengths placed on the property. Although the loan remained current due to interest reserves, the credit was classified substandard in a new appraisal order. Following receipt and review of the appraisal, the loan was charged down to the estimated current realizable value."
"Given the deteriorating market condition," Jordan said, "we continue to be proactive in identifying problem loans and in writing them down to realizable value, which includes disposition costs and adjustments for market declines since the last appraisal."
According to bankers, appraisers are also becoming more aggressive in writing down the value of real estate assets.
"What happened is that we are going through a very challenging time that when you have major developers like KB Homes and all of the big ones who are suddenly walking away from big developments in this kind of environment, appraisers are turning to extremely, extremely pessimistic views," said Dominic Ng, chairman, president and CEO of East West Bancorp.
Trickle Down into CRE
John D. Schwab, executive vice president and chief credit officer of Citizens Republic Bancorp Inc. said his bank saw 36 commercial real estate loans slip into the non-performing category.
"About half of them were what I’m going to call much smaller income producing properties where these are retail strips where there is vacancies where the cash flows are no longer supporting the currency of loans," Schwab said. "The chunkier ones happen to be, as I mentioned, both land development and income producing."
Harris H. Simmons, chairman, president and CEO of Zions Bancorporation, said his staff is seeing anecdotal evidence of a little bit of commercial deterioration in trades and businesses that are related to that market, for example, firms such as plumbers, electricians and so forth.
John Allison of BB&T said his banks are seeing the housing impact trickle into a host of other commercial businesses. "I think the impact in the automobiles business is pretty dramatic," Allison said. "I think the fact that people have less comfort in the equity in their homes, [and that lack of] security makes them less willing to do bigger purchases. It's impacting the furniture business pretty significantly. Obviously people buy furniture when they buy new homes and that's a deferrable purchase and so you have furniture retailers struggling."
Nonetheless, bankers are still generally comfortable with most aspects of their office, industrial and retail real estate portfolios and clients.
Whether you could translate auto dealer and furniture retailers' problems into shopping centers problems is an unknown, Allison said.
"I am in the process and every spring I get to visit all 33 of our community banks and I am having the opportunity to talk to lots of our small business, middle-sized business clients," he said. "And the story if you are in the residential construction development business is that you aren't having any fun."
That pessimism hasn't hit the commercial market yet, Allison added.
"If you are in the commercial end of the market, most everybody says things are fine, although they may not be fine going forward. I am not getting anybody on the commercial side that's not pretty optimistic," he said.
"One thing is that in the early '90s a lot of the downturn was commercial, not residential, because you had so much excess buildings," Allison said. "And this time around, you probably have some excess buildings, but it's nothing like the early '90s, where you had so much excess lot development in retrospect on the residential side. I think that's why you are having a much more serious correction on the residential versus commercial."
Gregory Smith, CFO and senior vice president of Marshall & Ilsley Corp., said, "fundamentals in the apartment, medical office, and warehousing segments are positive. Fundamentals in hospitality are currently good, however, we anticipate softening reflecting the economy in general and high gas prices. Retail and office demonstrates softening."
Dominic Ng of East West Bancorp, said the occupancy rates of shopping centers, hotels, industrial warehouses and office buildings in his Inland Empire market in Southern California are still holding up.
"Despite all of the concern about recession and so forth, we have not seen any kind of increase in vacancy rate in any substantial manner," Ng said. "There's a huge relief because interest rates have come down so much due to the Fed fund reduction. Now our customers used to pay about 7.5%, 8% to us and now they're paying, about 5.5%, 6% and they may be even lower but the rents are not dropping, so they're picking up even more cash flow."
On top of that, Ng said, unlike in the residential sector in which there is a huge glut of inventory, there is very little supply of commercial properties.
Fed Rate Cuts Have Produced Mixed Results
Not all banks agree that the rate cut has been a good thing or a stimulus. The escalating drop in interest rates over the winter occurred faster than the banks' could reprice their deposits. That prompted drops in net interest incomes for many banks.
Charles T. Canaday, Jr., president and CEO of MidCarolina Financial Corp., said, "The dramatic and rapid decreases in short-term interest rates during the first quarter, caused by the Federal Reserve's initiatives to stimulate our nation's economy which has been hampered by real estate related concerns, have negatively impacted our interest margin."
Hugh Potts, Jr., chairman and CEO First M&F Corp. also said, "First-quarter results are below last year's results and early expectations. The primary influence was the effect on the net interest margin brought about by the actions of the Federal Reserve in January and March to lower short-term rates," said. Potts added, "The Fed actions precipitated cuts in prime, which had an immediate negative impact on the margin. While we expect to recover margin as the year unfolds, its effect is evident."
That problem was particularly hard on banks that do a lot of commercial lending, said Ted Thomas Cecala, chairman and CEO of Wilmington Trust Corp. "Because we originate a larger number of commercial loans than any other type of loan, we tend to be access sensitive," Cecala said. "This means that when interest rates move, yields on our loan portfolio will adjust faster than our costs of deposits and national market funding. When the Fed moves interest rates, the effect on our floating rate assets is seen very quickly."
The Banker's Eye View of the Country
The Federal Reserve's latest monthly Beige Book lender survey issued in the past week concurs with what CoStar Advisor found in banks' first-quarter reports and comments.
Housing markets and home construction remained sluggish throughout most of the nation, but neither were there signs of any quickening in the pace of deterioration. New residential construction was reported to have remained at depressed levels, and none of the Federal Reserve districts reported any pickup since March.
Declines or downward pressures in residential selling prices were specifically reported in the Boston, New York, Philadelphia, Richmond, Atlanta, Chicago, Minneapolis, Kansas City, and San Francisco regions.
In particular, New York and San Francisco noted some incipient price declines in areas that had previously shown resilience - respectively, New York City and the Pacific Northwest, as well as Utah.
On the other hand, the Cleveland region noted some stabilization in home prices.
Commercial real estate markets were generally reported to be steady or softening in most areas. Weaker conditions in the rental market were reported in eight regions: New York, Philadelphia, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, and San Francisco.
On the other hand, the leasing markets were said to be steady in the Boston, Kansas City and Dallas areas.
Reports on commercial development were mixed with activity having weakened in the Philadelphia, Atlanta, and San Francisco regions, but having increased in the Cleveland, Chicago, and Kansas City Districts. St. Louis characterized commercial construction as strong.
Sales of commercial properties were generally indicated to be sluggish, while prices were said to be under downward pressure. The Boston, Philadelphia, Minneapolis, Kansas City, Dallas, and San Francisco regions all reported weakness in commercial real estate sales and prices.
Banks reported mixed trends in lending activity, with fairly widespread slowing in the consumer segment but some stabilization, at low levels, in residential mortgage activity.
Overall lending activity was reported to have increased in the Philadelphia, Richmond and St. Louis regions, but to have declined in the New York, Chicago, Kansas City and San Francisco regions.
The Dallas region described lending activity as steady but soft.
Lending activity for new home mortgages, though generally characterized as sluggish, was reported to have stabilized in the New York, Cleveland, Chicago, and San Francisco areas.
Consumer loan demand, however, weakened in a number of areas: New York, Atlanta, Chicago and Kansas City. Credit quality was reported to have deteriorated, on balance, since March. Increased delinquency rates were noted by New York, Philadelphia, and Cleveland, while Kansas City reported that loan quality remained lower than a year ago.
Widespread tightening in credit standards was reported, especially on residential and commercial real estate loans. In general, banks were reported to be tightening credit standards in the New York, Cleveland, Atlanta, Chicago, Kansas City, Dallas and San Francisco regions.
In addition, Boston noted that standards remain tight on commercial mortgages, while Philadelphia indicated that banks are limiting lending in this category. Richmond indicated tighter standards on residential mortgages.
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