The New Risks Facing Commercial Real Estate

Written by Thomas J. Curry
on July 06, 2012 No Comments
Categories : Word On The Street

11927_cre_flash The New Risks Facing Commercial Real Estate WORD ON THE STREET: National banks and federally chartered thrifts hold over $700 billion in total commercial real estate (CRE) loans, which amount to 14% of their aggregate loan portfolios. That's a big share of loans, but those numbers don't begin to describe the extent of CRE concentrations for community banks and thrifts, which tend to have much larger relative exposures. For banks and thrifts in the Office of the Comptroller of the Currency's (OCC) Community Bank Supervision program, CRE accounts for 37% of the total loan portfolio.

Of course, concentrations are a fact of life for small banks and thrifts that serve local communities that may lack the economic diversity of larger markets. The fortunes of a community institution in the farm belt might depend almost entirely on the price of corn, for example, no matter what kinds of loans it makes, and that's just a reflection of where it does business. Thus, concentrations have to be evaluated in context, and a vital element of that context is how institutions manage these concentrations and the capital they retain as a buffer against losses.

At the OCC, we recognize that CRE is a bread-and-butter product for community banks and thrifts that became even more important as increased competition from large institutions and non-banks constrained fee-and-interest income. For many community banks and thrifts, a well-managed portfolio of CRE is central to their continued long-term health.

On the other hand, however, it is also true that, in too many cases, concentrations in CRE have led to significant losses and failures of community banks. The vast majority of community bank failures over the past three years involved commercial real estate to some degree, and in most of these cases, that exposure was the primary reason for failure.

Our assessment of commercial credit risk takes into account the performance of different types of commercial loans. Construction and development (C&D) loans were, by far, the worst performers in the crisis, and concentrations in C&D proved to be a reliable indicator of the likelihood of failure for both national and state community banks. In March 2007, nearly 2,000 of these banks held C&D loans that exceeded their capital. By September of last year, 13% of them had failed.

If you expand the view to look at excessive real estate lending, look through the lens of the real estate guidance the regulatory agencies jointly issued in 2006. That guidance set thresholds of 100% of capital for construction lending and 300% of capital for total CRE. Where banks were in excess of those concentration thresholds, 23% failed. Where banks were within those thresholds only about one-half of 1% failed.

That's not to say that CRE concentrations threaten the viability of all community institutions. Far from it. The overwhelming majority of the banks and thrifts we supervise are managing their CRE exposures very well. Our message to these institutions is clear and consistent: Continue to work with borrowers who face difficulties, but also recognize and address problem credits by maintaining appropriate loan-loss reserves and taking appropriate charge-offs when repayment is unlikely.

Among large banks, there is good news and bad news. The bad news is that large-bank CRE portfolios performed worse than those of smaller institutions. The good news is that their exposures were much lower as a percentage of total loans or capital. That's not a new story. Large banks, by their nature, should have greater diversity both in product lines and market areas.

Community banks, on the other hand, don't always have the same opportunities to diversify. They simply have to be more nimble in their management of concentrations in both good times and bad.

And today, there's both good and bad news in the outlook for commercial real estate. We see real and tangible signs of improvement in CRE markets and CRE loan performance, and that gives us a reason for cautious optimism. However, as a supervisor, I have to be more concerned about the very strong headwinds these markets and their lenders still face. In fact, while we are seeing improvements in some of the fundamentals, even the positive trends come with qualifications and risks.

On the positive side, demand for multifamily housing is picking up, in no small part because homeownership rates dropped as the economy turned down, but supply is growing as well. Demand for office buildings is growing steadily, but moderately, reflecting the slow growth in employment. Demand for retail and warehouse space is also improving, due to increased consumption, but weakness in the housing market and technological advances that favor Internet sales over retail stores are hurting some segments of the market.

Although demand for CRE space is increasing, it remains soft relative to historical norms. Thus, while vacancy rates have improved, they are likely to remain elevated in many markets over the next couple of years. Rental rates and net operating income are well below peak levels, and net operating income is expected to continue to decline nationally for the next year or two for warehouse, office and retail space. Many leases signed during the boom will be renewed with lower rents, and that will continue to put downward pressure on net operating income.

Thus far, loans from the 2007 and earlier vintages have generally been extended or refinanced on a short-term basis as they matured. Up to half of all outstanding CRE loans will need to be rolled over by 2014, and many of these have been on interest-only terms or required only minimal amortization. Given the large volume of CRE loans maturing in the next one to two years, banks and CRE investors will have to resolve repayment issues, such as declining net operating income and underwater mortgages, while dealing with difficult economic conditions.

I can assure you that this is one of the issues we will be monitoring closely over time. Commercial mortgage loans have performed better than construction and development loans, but we should keep in mind that they are benefiting greatly from very low interest rates, and these loans will suffer if rates rise. While property valuations are no longer declining rapidly, they remain well below peak levels for many segments of the market and are projected to recover slowly, which will make it difficult for many existing loans to be refinanced if net operating income does not improve.

Thomas J. Curry is comptroller of the currency. This article was adapted and edited from a recent speech delivered before the CRE Finance Council. The original text is available online.

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