Archive for May, 2008

The 2004-2007 run up in commercial real estate prices was as big a wave as bankers and lenders had ever seen. And they were all eager to jump on board and ride the crest. They did and rode it well until it crashed ashore last summer and had property prices retreating back into a leveling sea.

Federal banking regulators, which had already started worrying about banks overextending themselves on the commercial real estate wave, are now wading in to assess the damage from the wave’s impact.

The U.S. Comptroller of the Currency, John C. Dugan said this past week that, with problem commercial real estate loans rising, it’s imperative that bank management identify and address problems realistically and that the OCC deal with national banks in a consistent and balanced way.

(Editor’s Note: This is the second of a two-part story examining the state of commercial real estate finance. CoStar Advisor 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 looked at the current state of commercial real estate markets from the lenders’ viewpoint. Part II of the story published here looks at how lenders are and will be responding to market conditions and their outlooks for the coming year.)

The Comptroller said that commercial real estate loans played an outsized role in the banking downturn of the late 1980s and early 1990s, and added that they weren’t anxious to see it repeated.

“Too many community banks today are having too hard a time coming to grips with problems in these portfolios” today, Dugan said. “These bankers are reluctant to charge off obviously troubled loans or even to flag problems to their examiners. While this resistance to recognizing problems at the beginning of an economic downturn may be human nature, it’s not healthy, because denial is not a strategy.”

The Comptroller underscored that the OCC plans to review banks more closely to address problems as they arise.

For clarification purposes, the vast majority of banks treat residential construction loans as commercial real estate lending because that is how federal banking regulators categorize such loans. 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.

On the other hand, as CoStar Advisor reported last week, commercial real estate markets were generally reported to be steady or softening in most areas. Still for the most part, Dugan’s message is getting across to banks, which are fairly aggressively beginning to reassess all their assets and address any problems and concerns head on.

Few have been clearer than Don Wilson, chief operating officer of Amcore Financial Inc., on how banks have reacted to the collapse of the residential real estate markets and consequent spillover into commercial real estate. Wilson outlined a 10-point strategy Amcore has followed as market conditions have deteriorated. And for the most part, various pieces of the plan are common across the industry right now.

Amcore Financial:

· Introduced a new risk rating system to provide more detailed information on the conditions underlying its portfolio;
· Reorganized its commercial credit approval process to provide more consistent credit control;
· Increased its reserves to cover more loans of concerns;
· Slowed the opening of new branches to only those that were already in the construction pipeline and terminated arrangements for others;
· Shifted the management of all the residential development loan relationships into a specialty unit with extensive experience in that market and product;
· Added staff and resources to its special assets group to pursue resolution of nonperforming assets;
· Reduced its commercial lending staff;
· Pursued an efficiency review across its organization and reduced overall staff 15%;
· Started implementing a new processing system to improve the accuracy, efficiency and information content of its commercial lending process; and
· Hired experienced commercial lenders to rebuild its commercial lending organization with less dependence on real estate lending.

The other element that has been common to the banks’ response to the credit crunch has been to go out and raise more capital from new investors.

Deloitte Financial Services hosted a seminar this past week entitled, “A Credit Crunch Update: Implications for Financial Institutions.” The accountancy firm said banks are moving through a three-stage cycle:

· Triage: dealing with the most severe problems first;
· Restructuring: Reducing costs, improving processes and reviewing products and distribution strategies; and
· Long-Term Rebuilding: Considering business consolidations or mergers and acquisitions.

This strategy Deloitte suggested would go on until investors have confidence that they can recognize value and begin to trade distressed assets.

That time of trading distressed assets, while it may have already started at some banks, is by no means universal in its appeal to banks and thus the return to normal may be a ways off.

Paul Beideman, chairman and CEO of Associated Banc-Corp. explained the reasoning.

“In this review process that we’ve gone through, we’ve gone back and looked at these loans very very closely and there is really very few of them that I would suggest that we would regret having made,” Beideman said. “It’s good high quality customers that have been in existence for quite sometime that for the reasons that again that are obvious, their prospects have deteriorated. But if we’ve underwritten them well, if the land is at 65% loan to value and we’ve applied conservative general standards to it, okay, it’s a nonperforming loan. But we are not going to take a 40%, 50% charge-off on the thing. We are going to — if there is a charge-off in at all — it’s going to be relatively small and in many cases it’s our hope that it just doesn’t exist.”

“Could we sell them,” Beideman asked. “Probably at some point we could [sell] some of them. But in this environment right now, the losses you are taking are exaggerated because of just the nature of the markets and the demand. And when we see our collateral position, it’s much enhanced over what those levels of alternatives would be.”

Richard J. Johnson, CFO of The PNC Financial Services Group Inc. said, “We continue to hold about $2.1 billion in held for sales loans. Our held for sale commercial mortgage loans are high quality assets that are performing as expected, in fact none of these loans were delinquent in the first quarter.”

“We intended to reduce our inventory in the first quarter,” Johnson added, “but we elected not to participate in the few deals that were in the marketplace. As we believe the fundamentals of these loans are better than what the market is offering today.”

And I love this quote from Robert E. Lowder, CEO of Colonial BancGroup Inc.

“There is a lot of liquidity out there for [bank assets],” Lowder said. “I mean, there’s money everywhere. Of course, they don’t want to pay any reasonable amounts. They want to pay 40 or 50 cents on the dollar. But just remember, these people that put together all these billions of dollars of funds and want to come down here and buy this property for 50 cents on the dollar, they’re not buying it because they think 12 months or 18 months or 24 months from now it’s still going to be worth 50 cents on the dollar. They’re buying it because it’s going to be worth $1.50.”

“So we think that the properties that we have, have good values,” Lowder said, “they have not decreased. The properties that are decreasing the greatest are the Grade C, D and F properties. We think our properties are better than that. So we just need to be careful that we don’t panic and give away properties this year that 12 months or 18 months from now are going to be worth a whole lot more than anybody paid.”

Dominic Ng, chairman, president and CEO of East West Bancorp, said many of his borrowers also are in no hurry yet to sell assets at prices buyers expect to pay in today’s markets.

“Let’s just assume the commercial real estate price will drop because of the illiquidity of the market and because of the media in New York Times, and Wall Street Journal and L.A. Times like to write bad news and keep saying the prices will go down, down, down, and then the prices do go down,” Ng said. “If the price does go down, I don’t think our borrowers need to be in a hurry to resolve it because they have good cash flow, they don’t need to sell.”

That doesn’t mean banks are not selling things – they’re selling CMBS holdings. For example, Wachovia Corp. substantially reduced its CMBS exposure from about $12 billion to net exposure of $3 billion as of the end of the first quarter and took a markdown of $521 million in doing so.

They’re selling branch buildings. For example, John Allison, chairman and CEO of BB&T Corp., said, “We are in the process of considering doing the sale of leaseback on a number of our physical facilities. We haven’t finalized the agreement and that would obviously depend on the pricing being something that is favorable to us. If we are able to execute the sale of leaseback it will increase [earnings per share] about 1 cent this year because of the timing, but the annual run rate going forward will be about 4 cents a year and we hope that transaction will get done in the next of quarters.”

For the most part, while banks go through this extensive review and re-engineering process, there has been little effort to lend new money. Or as Ng from East West put it, “This is not the year that we need to be out there every day and go to golf tournaments trying to solicit new customers.”

No, the whole focus on commercial real estate lending today is to maintain existing relationships – even with single-family developers.

Xandra McKeown, executive vice president of commercial banking at West Coast Bancorp, said, “We will continue to support new projects with our established developers and builders in submarkets that support additional inventory to have liquidity and comprehensive management expertise. We are not pursuing acquisition of new builder clients for single-family residential financing.”

What new deals that are getting done, McKeown said, are small condo projects that are in the process of converting to apartment, due to the lack of sales in the condo market but only with investors who have the liquidity.

Not all banks are sitting still, smaller community banks have seen an opening in the tighter credit conditions.

The “trickle down effect” from the subprime lending mortgage mess may be affecting the market and many communities, but “it’s also actually creating opportunity for financially strong community banks,” said Denny Buchanan, president and CEO of Independent Bank of Austin.

“Community banks, on the whole, did not participate in subprime lending because of the availability of secondary market financing, but the crisis affects our market, since we do lend funds for projects to buy and develop properties or to own a residence.”

“As a result, Independent Bank of Austin and other community banks are getting many great opportunities to be selective in funding solid loans – prudent choices based on sound principals. The current lending environment also allows us to get more equity into each project,” Buchanan noted. “That’s a huge change from even six months ago.”

For the near term, lenders across the nation foresee increasing bankruptcy rates, little or no growth from their customers and more tightening credit, according to the results of last quarter’s Phoenix Management “Lending Climate in America” survey.

And, they don’t think the economic stimulus package will help. An overwhelming majority of lenders (99%) said they believe that the economic stimulus package will have moderate to little impact on the U.S. economy over the next 12 months, Phoenix Management said.

Dale Green, executive vice president and chief credit policy officer for Comerica Inc. put it this way: “I would expect that the next two quarters would be the most challenging. If the markets continue to not rebound a bit, not a lot just a bit, then we’ll continue to see problems throughout the rest of ‘08 and potentially a little bit into ‘09.”

But George L. Engelke, Jr., chairman and CEO of Astoria Financial Corp., sums up nicely the bankers’ viewpoint of commercial real estate markets: “By no means do I see the entirety of America going to hell in real estate.”