BERNANKE ON COMMERCIAL REAL ESTATE
"We are concerned about it, it clearly is a very weak point in the economy. For many banks, including small and medium-sized banks, it is a problem. We have done a number of things. The Federal Reserve, working with the Treasury, has developed programs to try to restart the commercial mortgage-backed securities markets. Beyond that we have issued guidance to banks on commercial real estate and we're trying to work with them to restructure commercial real estate loans and to find ways to manage in terms of loans, so we're doing the best we can with banks and with the markets. There seems to be, I would say, a few glimmers of hope in this area, some stabilization of prices in some markets, for example, but it does remain a serious concern and we're watching it very carefully."
Wednesday, June 9, 2010
Sunday, April 4, 2010
Commercial Loan Workouts and Modifications
By Chuck Matheny
Commercial Equity Solutions, LLC
Many commercial borrowers now find themselves in the same condition today that a significant majority of homeowners are in. These commercial borrowers have negative equity or in other words their loan is greater than the value of their property. What is worse is that often the income from the property is not sufficient to pay the monthly debt service and taxes due on the property. This poses a problem when it comes to the end of the term of the loan and a refinance or extension is necessary. It also causes a more immediate problem of how will the commercial borrower pay the monthly loan and tax obligations.
This situation has evolved in most cases for two reasons; 1) the economy has caused many business’s to downsize or disappear thus causing increased vacancies and 2) due to the soft market many tenants have requested rent reductions from their landlord to help keep them in business and landlords have voluntarily granted them as it is most often in their best interest.
This situation leaves many commercial property owners in the tenuous situation of having to”feed the property” or support the monthly loan obligations while the property cannot sustain itself. At some point many owners have to determine if it is worth trying to hang on to their properties. The question that is often asked is do I want to keep spending good money after bad in this particular investment.
The lenders on the flip side are having no choice but to send out default notices if the payments due are past 30 days. If the lender feels that deficiencies are not curable and that the property is not being managed properly many will initiate some kind of foreclosure action and attempt to take the property back or at the very least appoint a receiver.
The good news in this scenario is that commercial lenders are realizing that it is often in their best interest not to aggressively pursue a foreclosure action. Often a better action is to modify on a temporary basis the terms of the note. Sometimes this can be done with the shortfall being forgiven by the lender. Some lenders are under such heavy regulatory pressure that the best solution is simply to move the note off their books through a short sale or short refinance. This can often be done where the lender will realize more than would come from a foreclosure. One key component in determining the best course of action for both lender and borrower is an accurate measure of the current value of the property. This is not an easy task where many of the comparables typically used in a valuation or appraisal are a balance between foreclosure sales and legitimate investor income or capitalization rate based sales. This value becomes a moving target. This is also one reason why appraisal firms are so busy. Values are changing monthly and have a wide range of variance.
If a short refinance is pursued as a course of action since the traditional commercial finance markets are so tight the best alternative is often private financing. This adds a whole new dimension of complexity to the process. Borrowers may even have to give up future equity to accomplish this short refinance with a private lender.
The other significant question that bears weight in the decision of what to do is the level of personal guarantees associated with the particular property. In many commercial properties, ownership involves multiple partners and this further complicates the situation. If some of the partners are not able to make necessary cash calls you can imagine the stress that is created.
Many borrowers would be well advised to get professional help in trying to make these difficult decisions, as there is usually significant equity at risk. Find someone that you feel will take the time to get familiar with the details of your commercial property. Also take the time to find someone that will understand the different values that your property will have in this distressed market. Finally, find a professional that will not be too pushy or adversarial with your lender as they are not obligated to do what the borrower desires to accomplish. Remember we are working for the most part in uncharted waters for both borrower and lender and no one knows how long these distressed market conditions will continue.
Commercial Equity Solutions, LLC
Many commercial borrowers now find themselves in the same condition today that a significant majority of homeowners are in. These commercial borrowers have negative equity or in other words their loan is greater than the value of their property. What is worse is that often the income from the property is not sufficient to pay the monthly debt service and taxes due on the property. This poses a problem when it comes to the end of the term of the loan and a refinance or extension is necessary. It also causes a more immediate problem of how will the commercial borrower pay the monthly loan and tax obligations.
This situation has evolved in most cases for two reasons; 1) the economy has caused many business’s to downsize or disappear thus causing increased vacancies and 2) due to the soft market many tenants have requested rent reductions from their landlord to help keep them in business and landlords have voluntarily granted them as it is most often in their best interest.
This situation leaves many commercial property owners in the tenuous situation of having to”feed the property” or support the monthly loan obligations while the property cannot sustain itself. At some point many owners have to determine if it is worth trying to hang on to their properties. The question that is often asked is do I want to keep spending good money after bad in this particular investment.
The lenders on the flip side are having no choice but to send out default notices if the payments due are past 30 days. If the lender feels that deficiencies are not curable and that the property is not being managed properly many will initiate some kind of foreclosure action and attempt to take the property back or at the very least appoint a receiver.
The good news in this scenario is that commercial lenders are realizing that it is often in their best interest not to aggressively pursue a foreclosure action. Often a better action is to modify on a temporary basis the terms of the note. Sometimes this can be done with the shortfall being forgiven by the lender. Some lenders are under such heavy regulatory pressure that the best solution is simply to move the note off their books through a short sale or short refinance. This can often be done where the lender will realize more than would come from a foreclosure. One key component in determining the best course of action for both lender and borrower is an accurate measure of the current value of the property. This is not an easy task where many of the comparables typically used in a valuation or appraisal are a balance between foreclosure sales and legitimate investor income or capitalization rate based sales. This value becomes a moving target. This is also one reason why appraisal firms are so busy. Values are changing monthly and have a wide range of variance.
If a short refinance is pursued as a course of action since the traditional commercial finance markets are so tight the best alternative is often private financing. This adds a whole new dimension of complexity to the process. Borrowers may even have to give up future equity to accomplish this short refinance with a private lender.
The other significant question that bears weight in the decision of what to do is the level of personal guarantees associated with the particular property. In many commercial properties, ownership involves multiple partners and this further complicates the situation. If some of the partners are not able to make necessary cash calls you can imagine the stress that is created.
Many borrowers would be well advised to get professional help in trying to make these difficult decisions, as there is usually significant equity at risk. Find someone that you feel will take the time to get familiar with the details of your commercial property. Also take the time to find someone that will understand the different values that your property will have in this distressed market. Finally, find a professional that will not be too pushy or adversarial with your lender as they are not obligated to do what the borrower desires to accomplish. Remember we are working for the most part in uncharted waters for both borrower and lender and no one knows how long these distressed market conditions will continue.
Tuesday, March 16, 2010
Commercial Loan Modification Article in National Mortgage Professional Magazine
Please read the following article I wrote for National Mortgage Professional Magazine.
"Commercial Loan Modification"
"Commercial Loan Modification"
Wednesday, March 3, 2010
Record CMBS Delinquencies Reported by Realpoint
Realpoint released their Monthly Delinquency Report. Here are some highlights and charts from their 15 page report.
In January 2010, the delinquent unpaid balance for CMBS increased by another $4.3 billion, up to $45.94 billion from $41.64 billion a month prior. The overall delinquent unpaid balance is up 326% from one-year ago (when only $10.79 billion of delinquent unpaid balance was reported for January 2009), and is now over 20 times the low point of $2.21 billion in March 2007. The distressed 90+-day, Foreclosure and REO categories grew in aggregate for the 25th straight month – up by $7.42 billion (28%) from the previous month and over $27.95 billion (508%) in the past year (up from only $5.51 billion in January 2009). This included a substantial jump in 90+-day delinquency in January 2010.
CMBS Delinquency Amounts
CMBS Delinquency Percentages
Geography
In January 2010, the delinquent unpaid balance for CMBS increased by another $4.3 billion, up to $45.94 billion from $41.64 billion a month prior. The overall delinquent unpaid balance is up 326% from one-year ago (when only $10.79 billion of delinquent unpaid balance was reported for January 2009), and is now over 20 times the low point of $2.21 billion in March 2007. The distressed 90+-day, Foreclosure and REO categories grew in aggregate for the 25th straight month – up by $7.42 billion (28%) from the previous month and over $27.95 billion (508%) in the past year (up from only $5.51 billion in January 2009). This included a substantial jump in 90+-day delinquency in January 2010.
CMBS Delinquency Amounts
All deals seasoned at least a year have a total unpaid balance of $789.07 billion, with $45.94 billion delinquent – a 5.82% rate (up from only 3.15% six months prior).
Geography
- The top three states ranked by delinquency exposure have remained consistent since January 2009, as California, Florida, and Texas collectively accounted for 30% of delinquency through January 2010.
- The 10 largest states by delinquent unpaid balance reflect 57% of CMBS delinquency, while the 10 largest states by overall CMBS exposure reflect 52% of the CMBS universe.
- The state of California remains a major concern at near 13% of CMBS delinquency. By MSA, however, such delinquency is concentrated in the Los Angeles, Riverside-San Bernardino, and Orange County MSAs highlighted below.
- While by state delinquency exposure Florida ranks second, no Florida MSA is found in the Top 10 MSA’s ranked by delinquency exposure (highest being Miami, which ranked 14th in our data).
- Notably, over 10% of total CMBS exposure in the states of Florida, Arizona, Nevada and Michigan are delinquent, with the Phoenix, AZ and Las Vegas, NV MSAs accounting for the top 2 by delinquency exposure at (14% and 14.5% of the MSAs, respectively).
- Credit also appears to be deteriorating further in the Riverside-San Bernardino, CA MSA, as over 11% of the total MSA exposure was reported delinquent through January 2010.
- Texas delinquency is highly concentrated within the Dallas-Fort Worth and Houston MSAs.
- Only one MSA topped 4% of CMBS delinquency in January 2010, consistent with the prior month.
- The 10 largest MSAs by delinquent unpaid balance reflect 30% of CMBS delinquency, while the 10 largest MSAs by overall CMBS exposure reflect 34% of the CMBS universe.
Tuesday, March 2, 2010
Video: How Will The CRE Bubble Be Resolved?
Watch this interesting discussion on the commercial real estate crisis. Tom Flexner, head of real estate at Citigroup, and Richard LeFrak, president of the LeFrak Organization, talk to CNBC.
Billions in opportunistic private money remain on the sidelines as the large rift between buyers and sellers highlights the state of commercial lending.
Billions in opportunistic private money remain on the sidelines as the large rift between buyers and sellers highlights the state of commercial lending.
Tuesday, February 23, 2010
Congressional Oversite Panel Issues Gloomy CRE Report
The Congressional Oversight Panel issued its 190 page report on CRE . Find the executive summary below. The complete report is available at http://cop.senate.gov/documents/cop-021110-report.pdf
Executive Summary
Over the next few years, a wave of commercial real estate loan failures could threaten America’s already-weakened financial system. The Congressional Oversight Panel is deeply concerned that commercial loan losses could jeopardize the stability of many banks, particularly the nation’s mid-size and smaller banks, and that as the damage spreads beyond individual banks that it will contribute to prolonged weakness throughout the economy.
Between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are at present “underwater” – that is, the borrower owes more than the underlying property is currently worth. Commercial property values have fallen more than 40 percent since the beginning of 2007. Increased vacancy rates, which now range from eight percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties.
The largest commercial real estate loan losses are projected for 2011 and beyond; losses at banks alone could range as high as $200-$300 billion. The stress tests conducted last year for 19 major financial institutions examined their capital reserves only through the end of 2010.
Even more significantly, small and mid-sized banks were never subjected to any exercise comparable to the stress tests, despite the fact that small and mid-sized banks are proportionately even more exposed than their larger counterparts to commercial real estate loan losses.
A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American. Empty office complexes, hotels, and retail stores could lead directly to lost jobs. Foreclosures on apartment complexes could push families out of their residences, even if they had never missed a rent payment. Banks that suffer, or are afraid of suffering, commercial mortgage losses could grow even more reluctant to lend, which could in turn further reduce access to credit for more businesses and families and accelerate a negative economic cycle.
It is difficult to predict either the number of foreclosures to come or who will be most immediately affected. In the worst case scenario, hundreds more community and mid-sized banks could face insolvency. Because these banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery, and extend an already painful recession.
Present Condition of Commercial Real Estate
The commercial real estate market is currently experiencing considerable difficulty for two distinct reasons. First, the current economic downturn has resulted in a dramatic deterioration of commercial real estate fundamentals. Increasing vacancy rates and falling rental prices present problems for all commercial real estate loans. Decreased cash flows will affect the ability of borrowers to make required loan payments. Falling commercial property values result in higher LTV ratios, making it harder for borrowers to refinance under current terms regardless of the soundness of the original financing, the quality of the property, and whether the loan is performing.
Second, the development of the commercial real estate bubble, as discussed above, resulted in the origination of a significant amount of commercial real estate loans based on dramatically weakened underwriting standards. These loans were based on overly aggressive rental or cash flow projections (or projections that were only sustainable under bubble conditions), had higher levels of allowable leverage, and were not soundly underwritten. Loans of this sort (somewhat analogous to “Alt-A” residential loans) will encounter far greater difficulty as projections fail to materialize on already excessively leveraged commercial properties.
Economic Conditions and Deteriorating Market Fundamentals
The health of the commercial real estate market depends on the health of the overall economy. Consequently, the market fundamentals will likely stay weak for the foreseeable future. This means that even soundly financed projects will encounter difficulties. Those projects that were not soundly underwritten will likely encounter far greater difficulty as aggressive rental growth or cash flow projections fail to materialize, property values drop, and LTV ratios rise on already excessively leveraged properties. New and partially constructed properties are experiencing the biggest problems with vacancy and cash flow issues (leading to a higher number of loan defaults and higher loss severity rates than other commercial property loans).
For the last several quarters, average vacancy rates have been rising and average rental prices have been falling for all major commercial property types.
Current average vacancy rates and rental prices have been buffered by the long-term leases held by many commercial properties (e.g., office and industrial). The combination of negative net absorption rates and additional space that will become available from projects started during the boom years will cause vacancy rates to remain high, and will continue putting downward pressure on rental prices for all major commercial property types. Taken together, this falling demand and already excessive supply of commercial property will cause many projects to be viable no longer, as properties lose, or are unable to obtain, tenants and as cash flows (actual or projected) fall.
In addition to deteriorating market fundamentals, the price of commercial property has plummeted. As seen in the following chart, commercial property values have fallen over 40 percent since the beginning of 2007.
For financial institutions, the ultimate impact of the commercial real estate whole loan problem will fall disproportionately on smaller regional and community banks that have higher concentrations of, and exposure to, such loans than larger national or money center banks. The impact of commercial real estate problems on the various holders of CMBS and other participants in the CMBS markets is more difficult to predict. The experience of the last two years, however, indicates that both risks can be serious threats to the institutions and borrowers involved.
Although banks with over $10 billion in assets hold over half of commercial banks’ total commercial real estate whole loans, the mid-size and smaller banks face the greatest exposure.
The current distribution of commercial real estate loans may be particularly problematic for the small business community because smaller regional and community banks with substantial commercial real estate exposure account for almost half of small business loans. For example, smaller banks with the highest exposure – commercial real estate loans in excess of three times Tier 1 capital – provide around 40 percent of all small business loans.
Foresight Analytics, a California-based firm specializing in real estate market research and analysis, calculates banks’ exposure to commercial real estate to be even higher than that estimated by the Federal Reserve. Drawing on bank regulatory filings, including call reports and thrift financial reports, Foresight estimates that the total commercial real estate loan exposure of commercial banks is $1.9 trillion compared to the $1.5 trillion Federal Reserve estimate. The 20 largest banks, those with assets greater than $100 billion, hold $600.5 billion in commercial real estate loans.
Figure 17: Commercial Real Estate Loans by Type (Banks and Thrifts as of Q3 2009)
As seen in the Foresight Analytics data above, the mid-size and smaller institutions have the largest percentage of “CRE Concentration” banks compared to total banks within their respective asset class. This percentage is especially high in banks with $1 billion to $10 billion in assets. The table above emphasizes the heightened commercial real estate exposure compared to total capital in banks with $100 million to $10 billion in assets. Equally troubling, at least six of the nineteen stress-tested bank-holding companies have whole loan exposures in excess of 100 percent of Tier 1 risk-based capital.
Risks
In the years preceding the current crisis, a series of trends pushed smaller and community banks toward greater concentration of their lending activities in commercial real estate. Simultaneously, higher quality commercial real estate projects tended to secure their financing in the CMBS market. As a result, if and when a crisis in commercial real estate develops, smaller and community banks will have greater exposure to lower quality investments, making them uniquely vulnerable.
As loan delinquency rates rise, many commercial real estate loans are expected to default prior to maturity. For loans that reach maturity, borrowers may face difficulty refinancing either because credit markets are too tight or because the loans do not qualify under new, stricter underwriting standards. If the borrowers cannot refinance, financial institutions may face the unenviable task of determining how best to recover their investments or minimize their losses: restructuring or extending the term of existing loans or foreclosure or liquidation.
On the other hand, borrowers may decide to walk away from projects or properties if they are unwilling to accept terms that are unfavorable or fear the properties will not generate sufficient cash flows or operating income either to service new debt or to generate a future profit.
Delinquent Loans
Although many analysts and Treasury officials believe that the commercial real estate problem is one that the economy can manage through, and analysts believe that the current condition of commercial real estate, in isolation, does not pose a systemic risk to the banking system, rising delinquency rates foreshadow continuing deterioration in the commercial real estate market. For the last several quarters, delinquency rates have been rising significantly.
The extent of ultimate commercial real estate losses is yet to be determined; however, large loan losses and the failure of some small and regional banks appear to some experienced analysts to be inevitable. New 30-day delinquency rates across commercial property types continue to rise, suggesting that commercial real estate loan performance will continue to deteriorate. However, there is some indication that the rate of growth, or pace of deterioration, is slowing. Unsurprisingly, the increase in delinquency rates has translated into rapidly rising default rates.
The increasing number of delinquent, defaulted, and non-performing commercial real estate loans also reflects increasing levels of loan risks. Loan risks for borrowers and lenders fall into two categories: credit risk and term risk. Credit risk can lead to loan defaults prior to maturity; such defaults generally occur when a loan has negative equity and cash flows from the property are insufficient to service the debt, as measured by the debt service coverage ratio (DSCR).
If the DSCR falls below one, and stays below one for a sufficiently long period of time, the borrower may decide to default rather than continue to invest time, money, or energy in the property. The borrower will have little incentive to keep a property that is without equity and is not generating enough income to service the debt, especially if he does not expect the cash flow situation to improve because of increasing vacancy rates and falling rental prices.
Broader Social and Economic Consequences
Commercial real estate problems exacerbate rising unemployment rates and declining consumer spending. Approximately nine million jobs are generated or supported by commercial real estate including jobs in construction, architecture, interior design, engineering, building maintenance and security, landscaping, cleaning services, management, leasing, investment and mortgage lending, and accounting and legal services.
Projects that are being stalled or canceled and properties with vacancy issues are leading to layoffs. Lower commercial property values and rising defaults are causing erosion in retirement savings, as institutional investors, such as pension plans, suffer further losses. Decreasing values also reduce the amount of tax revenue and fees to state and local governments, which in turn impacts the amount of funding for public services such as education and law enforcement. Finally, problems in the commercial real estate market can further reduce confidence in the financial system and the economy as a whole. To make matters worse, the credit contraction that has resulted from the overexposure of financial institutions to commercial real estate loans, particularly for smaller regional and community banks, will result in a “negative feedback loop” that suppresses economic recovery and the return of capital to the commercial real estate market. The fewer loans that are available for businesses, particularly small businesses, will hamper employment growth, which could contribute to higher vacancy rates and further problems in the commercial real estate market.
Conclusion
There is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public. An extended severe recession and continuing high levels of unemployment can drive up the LTVs, and add to the difficulties of refinancing for even solidly underwritten properties. But delaying write-downs in advance of a hoped-for recovery in mid- and longer-term property valuations also runs the risk of postponing recognition of the costs that must ultimately be absorbed by the financial system to eliminate the commercial real estate overhang.
Any approach to the problem raises issues previously identified by the Panel: the creation of moral hazard, subsidization of financial institutions, and providing a floor under otherwise seriously undercapitalized institutions.
There appears to be a consensus, strongly supported by current data, that commercial real estate markets will suffer substantial difficulties for a number of years. Those difficulties can weigh heavily on depository institutions, particularly mid-size and community banks that hold a greater amount of commercial real estate mortgages relative to total size than larger institutions, and have – especially in the case of community banks – far less margin for error. But some aspects of the structure of the commercial real estate markets, including the heavy reliance on CMBS (themselves backed in some cases by CDS) and the fact that at least one of the nation’s largest financial institutions holds a substantial portfolio of problem loans, mean that the potential for a larger impact is also present.
There is no way to predict with assurance whether an economic recovery of sufficient strength will occur to reduce these risks before the large-scale need for commercial mortgage refinancing that is expected to begin in 2011-2013.
The Panel is concerned that until Treasury and bank supervisors take coordinated action to address forthrightly and transparently the state of the commercial real estate markets – and the potential impact that a breakdown in those markets could have on local communities, small businesses, and individuals – the financial crisis will not end.
Executive Summary
Over the next few years, a wave of commercial real estate loan failures could threaten America’s already-weakened financial system. The Congressional Oversight Panel is deeply concerned that commercial loan losses could jeopardize the stability of many banks, particularly the nation’s mid-size and smaller banks, and that as the damage spreads beyond individual banks that it will contribute to prolonged weakness throughout the economy.
Between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are at present “underwater” – that is, the borrower owes more than the underlying property is currently worth. Commercial property values have fallen more than 40 percent since the beginning of 2007. Increased vacancy rates, which now range from eight percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties.
The largest commercial real estate loan losses are projected for 2011 and beyond; losses at banks alone could range as high as $200-$300 billion. The stress tests conducted last year for 19 major financial institutions examined their capital reserves only through the end of 2010.
Even more significantly, small and mid-sized banks were never subjected to any exercise comparable to the stress tests, despite the fact that small and mid-sized banks are proportionately even more exposed than their larger counterparts to commercial real estate loan losses.
A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American. Empty office complexes, hotels, and retail stores could lead directly to lost jobs. Foreclosures on apartment complexes could push families out of their residences, even if they had never missed a rent payment. Banks that suffer, or are afraid of suffering, commercial mortgage losses could grow even more reluctant to lend, which could in turn further reduce access to credit for more businesses and families and accelerate a negative economic cycle.
It is difficult to predict either the number of foreclosures to come or who will be most immediately affected. In the worst case scenario, hundreds more community and mid-sized banks could face insolvency. Because these banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery, and extend an already painful recession.
Present Condition of Commercial Real Estate
The commercial real estate market is currently experiencing considerable difficulty for two distinct reasons. First, the current economic downturn has resulted in a dramatic deterioration of commercial real estate fundamentals. Increasing vacancy rates and falling rental prices present problems for all commercial real estate loans. Decreased cash flows will affect the ability of borrowers to make required loan payments. Falling commercial property values result in higher LTV ratios, making it harder for borrowers to refinance under current terms regardless of the soundness of the original financing, the quality of the property, and whether the loan is performing.
Second, the development of the commercial real estate bubble, as discussed above, resulted in the origination of a significant amount of commercial real estate loans based on dramatically weakened underwriting standards. These loans were based on overly aggressive rental or cash flow projections (or projections that were only sustainable under bubble conditions), had higher levels of allowable leverage, and were not soundly underwritten. Loans of this sort (somewhat analogous to “Alt-A” residential loans) will encounter far greater difficulty as projections fail to materialize on already excessively leveraged commercial properties.
Economic Conditions and Deteriorating Market Fundamentals
The health of the commercial real estate market depends on the health of the overall economy. Consequently, the market fundamentals will likely stay weak for the foreseeable future. This means that even soundly financed projects will encounter difficulties. Those projects that were not soundly underwritten will likely encounter far greater difficulty as aggressive rental growth or cash flow projections fail to materialize, property values drop, and LTV ratios rise on already excessively leveraged properties. New and partially constructed properties are experiencing the biggest problems with vacancy and cash flow issues (leading to a higher number of loan defaults and higher loss severity rates than other commercial property loans).
For the last several quarters, average vacancy rates have been rising and average rental prices have been falling for all major commercial property types.
Current average vacancy rates and rental prices have been buffered by the long-term leases held by many commercial properties (e.g., office and industrial). The combination of negative net absorption rates and additional space that will become available from projects started during the boom years will cause vacancy rates to remain high, and will continue putting downward pressure on rental prices for all major commercial property types. Taken together, this falling demand and already excessive supply of commercial property will cause many projects to be viable no longer, as properties lose, or are unable to obtain, tenants and as cash flows (actual or projected) fall.
In addition to deteriorating market fundamentals, the price of commercial property has plummeted. As seen in the following chart, commercial property values have fallen over 40 percent since the beginning of 2007.
For financial institutions, the ultimate impact of the commercial real estate whole loan problem will fall disproportionately on smaller regional and community banks that have higher concentrations of, and exposure to, such loans than larger national or money center banks. The impact of commercial real estate problems on the various holders of CMBS and other participants in the CMBS markets is more difficult to predict. The experience of the last two years, however, indicates that both risks can be serious threats to the institutions and borrowers involved.
Although banks with over $10 billion in assets hold over half of commercial banks’ total commercial real estate whole loans, the mid-size and smaller banks face the greatest exposure.
The current distribution of commercial real estate loans may be particularly problematic for the small business community because smaller regional and community banks with substantial commercial real estate exposure account for almost half of small business loans. For example, smaller banks with the highest exposure – commercial real estate loans in excess of three times Tier 1 capital – provide around 40 percent of all small business loans.
Foresight Analytics, a California-based firm specializing in real estate market research and analysis, calculates banks’ exposure to commercial real estate to be even higher than that estimated by the Federal Reserve. Drawing on bank regulatory filings, including call reports and thrift financial reports, Foresight estimates that the total commercial real estate loan exposure of commercial banks is $1.9 trillion compared to the $1.5 trillion Federal Reserve estimate. The 20 largest banks, those with assets greater than $100 billion, hold $600.5 billion in commercial real estate loans.
Figure 17: Commercial Real Estate Loans by Type (Banks and Thrifts as of Q3 2009)
As seen in the Foresight Analytics data above, the mid-size and smaller institutions have the largest percentage of “CRE Concentration” banks compared to total banks within their respective asset class. This percentage is especially high in banks with $1 billion to $10 billion in assets. The table above emphasizes the heightened commercial real estate exposure compared to total capital in banks with $100 million to $10 billion in assets. Equally troubling, at least six of the nineteen stress-tested bank-holding companies have whole loan exposures in excess of 100 percent of Tier 1 risk-based capital.
Risks
In the years preceding the current crisis, a series of trends pushed smaller and community banks toward greater concentration of their lending activities in commercial real estate. Simultaneously, higher quality commercial real estate projects tended to secure their financing in the CMBS market. As a result, if and when a crisis in commercial real estate develops, smaller and community banks will have greater exposure to lower quality investments, making them uniquely vulnerable.
As loan delinquency rates rise, many commercial real estate loans are expected to default prior to maturity. For loans that reach maturity, borrowers may face difficulty refinancing either because credit markets are too tight or because the loans do not qualify under new, stricter underwriting standards. If the borrowers cannot refinance, financial institutions may face the unenviable task of determining how best to recover their investments or minimize their losses: restructuring or extending the term of existing loans or foreclosure or liquidation.
On the other hand, borrowers may decide to walk away from projects or properties if they are unwilling to accept terms that are unfavorable or fear the properties will not generate sufficient cash flows or operating income either to service new debt or to generate a future profit.
Delinquent Loans
Although many analysts and Treasury officials believe that the commercial real estate problem is one that the economy can manage through, and analysts believe that the current condition of commercial real estate, in isolation, does not pose a systemic risk to the banking system, rising delinquency rates foreshadow continuing deterioration in the commercial real estate market. For the last several quarters, delinquency rates have been rising significantly.
The extent of ultimate commercial real estate losses is yet to be determined; however, large loan losses and the failure of some small and regional banks appear to some experienced analysts to be inevitable. New 30-day delinquency rates across commercial property types continue to rise, suggesting that commercial real estate loan performance will continue to deteriorate. However, there is some indication that the rate of growth, or pace of deterioration, is slowing. Unsurprisingly, the increase in delinquency rates has translated into rapidly rising default rates.
The increasing number of delinquent, defaulted, and non-performing commercial real estate loans also reflects increasing levels of loan risks. Loan risks for borrowers and lenders fall into two categories: credit risk and term risk. Credit risk can lead to loan defaults prior to maturity; such defaults generally occur when a loan has negative equity and cash flows from the property are insufficient to service the debt, as measured by the debt service coverage ratio (DSCR).
If the DSCR falls below one, and stays below one for a sufficiently long period of time, the borrower may decide to default rather than continue to invest time, money, or energy in the property. The borrower will have little incentive to keep a property that is without equity and is not generating enough income to service the debt, especially if he does not expect the cash flow situation to improve because of increasing vacancy rates and falling rental prices.
Broader Social and Economic Consequences
Commercial real estate problems exacerbate rising unemployment rates and declining consumer spending. Approximately nine million jobs are generated or supported by commercial real estate including jobs in construction, architecture, interior design, engineering, building maintenance and security, landscaping, cleaning services, management, leasing, investment and mortgage lending, and accounting and legal services.
Projects that are being stalled or canceled and properties with vacancy issues are leading to layoffs. Lower commercial property values and rising defaults are causing erosion in retirement savings, as institutional investors, such as pension plans, suffer further losses. Decreasing values also reduce the amount of tax revenue and fees to state and local governments, which in turn impacts the amount of funding for public services such as education and law enforcement. Finally, problems in the commercial real estate market can further reduce confidence in the financial system and the economy as a whole. To make matters worse, the credit contraction that has resulted from the overexposure of financial institutions to commercial real estate loans, particularly for smaller regional and community banks, will result in a “negative feedback loop” that suppresses economic recovery and the return of capital to the commercial real estate market. The fewer loans that are available for businesses, particularly small businesses, will hamper employment growth, which could contribute to higher vacancy rates and further problems in the commercial real estate market.
Conclusion
There is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public. An extended severe recession and continuing high levels of unemployment can drive up the LTVs, and add to the difficulties of refinancing for even solidly underwritten properties. But delaying write-downs in advance of a hoped-for recovery in mid- and longer-term property valuations also runs the risk of postponing recognition of the costs that must ultimately be absorbed by the financial system to eliminate the commercial real estate overhang.
Any approach to the problem raises issues previously identified by the Panel: the creation of moral hazard, subsidization of financial institutions, and providing a floor under otherwise seriously undercapitalized institutions.
There appears to be a consensus, strongly supported by current data, that commercial real estate markets will suffer substantial difficulties for a number of years. Those difficulties can weigh heavily on depository institutions, particularly mid-size and community banks that hold a greater amount of commercial real estate mortgages relative to total size than larger institutions, and have – especially in the case of community banks – far less margin for error. But some aspects of the structure of the commercial real estate markets, including the heavy reliance on CMBS (themselves backed in some cases by CDS) and the fact that at least one of the nation’s largest financial institutions holds a substantial portfolio of problem loans, mean that the potential for a larger impact is also present.
There is no way to predict with assurance whether an economic recovery of sufficient strength will occur to reduce these risks before the large-scale need for commercial mortgage refinancing that is expected to begin in 2011-2013.
The Panel is concerned that until Treasury and bank supervisors take coordinated action to address forthrightly and transparently the state of the commercial real estate markets – and the potential impact that a breakdown in those markets could have on local communities, small businesses, and individuals – the financial crisis will not end.
Thursday, February 4, 2010
CMBS Trusts Take Beating As Loans Are Liquidated
December 2009 saw the largest ever liquidation of commercial mortgage backed securities. Over half a billion dollars in loans were removed from REMICs (real estate mortgage investment conduits) books. This represents a five fold increase over the same period last year.
Investors in these CMBS bonds lost hundreds of millions. Most of the loans were sold for less than 50% of their face value and some even sold for less then 10 cents on the dollar.
2009 ended with loans over $60 billion in special servicing, up from only $12.8 billion 12 months earlier. A loan that is in special servicing is a loan that is either in default or likely to default soon.
Over $40 billion of CMBS loans were behind in payments as of the end of December, according to Realpoint, a nationally recognized credit-rating agency.
Investors in these CMBS bonds lost hundreds of millions. Most of the loans were sold for less than 50% of their face value and some even sold for less then 10 cents on the dollar.
2009 ended with loans over $60 billion in special servicing, up from only $12.8 billion 12 months earlier. A loan that is in special servicing is a loan that is either in default or likely to default soon.
Over $40 billion of CMBS loans were behind in payments as of the end of December, according to Realpoint, a nationally recognized credit-rating agency.
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