Heavy bank exposure to commercial real estate
November 13, 2009 1 Comment
Many banks cannot lend for commercial properties until they know where they stand with respect to their exposure to at-risk properties. A majority of banks will end up holding commercial property in 2010 that they had to foreclose or the owner could not refinance.
Banks are the majority holders of commercial real estate debt. Banks currently hold 60% of commerial real estate debt. A lot of that debt is coming due in 2010 and there is little available credit to refinance those loans through banks. A majority of the delinquent but still active CRE loans are in the construction and development sector, but the non-farm, non-residential CRE loans are rapidly increasing in their delinquencies as well.
Another strong factor is that commercial real estate vacancies are strongly tied to unemployment levels. As many forecasters are now calling for 12-13% unemployment rates, the impact on office and retail occupancy rates is clear. Lower occupancy rates equates to lower income to building owners which equates to missed and delinquent debt payments on their CRE mortgages.
Another clear factor is the impact of this long economic draught on CRE valuations. If you purchased a property 2 years ago for $2 million, you need to get a certain amount of income from your tenant in order to make the debt payment. With so much vacant space, incentives for tenants are driving down rent rates. This means your $2 million building can now only earn enough rent, for example, to cover 80% of the debt. So your challenge is to either eat 20% of your debt payment each month or negotiate with your bank to reduce the value of the property and the amount of your mortgage – called a loan modification. The bank then takes on the burden of writing off the reduction in the debt amount.
Of course, what happens if the bank doesn’t agree to modify your loan terms? You have a few, very unappealing choices. First, you could go back to paying the difference between your tenant income and your debt amount out of your own pocket. This could be a long term cash flow issue, so weigh this choice very carefully based on your lease terms. The second choice is to just stop paying the debt all together and walk away from the property. The bank forecloses and they end up owning the property at a reduced valuation anyhow. Not only does the bank write off your mortgage, they now own a building – which is usually the last thing a bank wants. They have neither the manpower nor knowledge to manage a commercial property long term.
This is exactly what happened to 2 deals I worked on this year. In one case, the owner executed a Deed In Lieu of Foreclosure to get out from under the property. In another case, the owner went to negotiate with the bank to do a loan modification and the bank took so long to decide, the tenant walked away and now there is absolutely no income stream and the owner has no choice but to walk away from the building.
I can’t pretend to know what will happen in the next 12 months, but based on my personal experience and from how I see banks handling their CRE customers right now, I believe the whole banking system is going to get much worse before it gets better. Banks are terrified to make decisions right now because they know the fed is watching every move they make. So they decide not to decide. Which allows the chips to fall where they may. Banks are not being ‘run’ right now as much as they are being allowed to crumble in place. We have hit a new record of more than 120 banks being closed and/or taken over by the gov’t in 2009. With so much exposure to commercial real estate debt and the lack of available credit to refinance maturing loans, banks are really in a pinch. The next 2 quarters are going to be quite revealing and could potentially drive significant change in the banking industry.
Hang on to your hats…
- Michael
