Community banks’ involvement with commercial real estate can be broken into three phases. There is an aggressive past that is still being paid for; a present that in many markets mixes inactivity with occasional frenetic competition; and a future where the economics will be very different, and where the seeds of potential further trouble have already been planted.
That’s not exactly an upbeat summary. And it’s a composite picture. But when you are dealing with the aftermath of a crisis, simply still being around to talk about it has a great deal to be said for it.
“The worst is behind us,” says Keith Leggett, ABA senior economist. CRE asset quality is improving, vacancies overall are falling, and prices in many markets are firming, albeit at lower levels. Industrywide, FDIC reported in late February, net charge-offs fell by 40.2% in fourth-quarter 2011, versus fourth-quarter 2012, with charge-offs on real estate construction and land development loans, a facet of CRE lending, falling by 62.4%. Noncurrent loan balances in two key categories fell, too: real estate construction and land development loans, by 13.2% in the fourth quarter, compared to the third, likewise nonfarm nonresidential real estate loans, by 4%.
On the other hand, observers say many community banks have seen their CRE activity shrink, between falling activity, retiring debt, and write-offs. “It’s a regrouping time for most institutions,” says Scott Miller, principal in the risk consulting practice at Crowe Horwath LLP. “This has been a real negative environment for people—they are getting fatigued.”
Playing out the hand
Many of the bank failures brought on by CRE have been processed by FDIC. However, write-downs of existing loans in portfolio continue. Miller says he doesn’t find much that’s positive yet on the CRE front. These days, he says a good deal of his practice touches on clients’ loan loss reserve, and he frequently has to push the question: “Are we really going to get all of these problem real estate loans worked out?”
Some banks simply lack the capital to take a harshly realistic view on their CRE portfolios, says Miller, and so they are currently “doing a dance” until they next see regulators. “That will correct itself at the next exam,” he explains.
Miller’s view may sound tough, but bankers also number among the realists. Georgia banker Dan Blanton, a veteran real estate lender with real estate industry experience, as well, brooks no middle ground.
“In this environment, you have to get this stuff off your books,” says Blanton. “You can’t sit on property either.” While some bankers say examiners push too hard for disposal of Other Real Estate Owned (OREO), Blanton points to stagnant prices and shrugs, “I don’t know when values are going to return.” In other words, cut your losses and move on.
Not every bad loan has to be written off. Bankers have been engaging in workouts where they can. Most of those interviewed say they found little they didn’t already know in the interagency “Policy Statement on Prudent Commercial Real Estate Loan Workouts,” published in October 2009. However, Michelle Lucci, a former banker and examiner and now CRE risk management consultant for Bankers Toolbox, sees evidence in FDIC’s quarterly numbers that a great deal of CRE debt has been rewritten in hopes of successful workouts. (Bankers Toolbox, an ABA-endorsed company, offers CRE stress testing services.)
There are banks, or even markets, where CRE troubles didn’t reach debacle levels. “Not all community banks held their noses and jumped in the same way,” says Constantine “Tino” Korologos, managing director, Deloitte Corporate Finance LLC. He points out that some of the “orphan” properties out there—e.g. pristine new strip malls sitting empty throughout the crisis—weren’t even bank-financed. Many were projects pushed along by investment banks anxious to generate product for commercial real estate mortgage conduits.
Before any return to “normality,” there’s much to overcome. “‘Yellow light’ isn’t an unreasonable description,” says Korologos. “You’ve got to watch where you’re going.”
One hopeful sign: Crowe Horwath’s Miller says that appraisals, a burr in bankers’ side in the early and middle days of the crisis, have leveled off from the dramatic reductions that became common. He says that is bringing back some stability.
A market-by-market affair
They say that all politics is local, and, especially in this period, commercial real estate and CRE lending also play out very much as a local affair. ABA’s Keith Leggett says a bank’s experience in CRE right now hinges on where it competes and what aspects of CRE it participates in. Among many community banks, if they are lending at all on CRE, they are looking mostly at owner-occupied properties, rather than speculative construction lending. Manufacturing facilities have held up versus other property types nationally, he says, as have larger office complexes in some areas.
Office projects, however, are frequently too large for a community bank to tackle. Participations don’t appeal any longer to many because the crisis period saw many burned. “They want to deal with what they know and what they are comfortable with,” says Leggett.
At this point, some banks remain in heavy cleanup mode, and many of the rest are in something of a CRE holding pattern: They’re managing what they have, and are not making many new loans.
After a flat 2011, bankers should mostly expect a “bumpy” 2012, says Colette Prior, senior executive at Accenture Credit Services. Anything like a comeback is “very early in the game” to be discussing.
The roundup in the next section looks at market-by-market differences and similarities.
Unfortunately, CRE isn’t standing still in the big picture or the small. As a later section will explore, loans made in 2005, 2006, and 2007, as a general range, will be rolling over in the near future at lower rates. With the Federal Reserve committed to those low rates through 2014, and the cost of funds realistically unable to fall further, margins on what had been a lucrative business line will change.
“The fundamentals are different,” says Leggett. “They’ll find that they won’t have a lot of margin in this business and that’s the new reality: margins squeezed further and further.” These economics, and the intensifying competition being seen where there is new activity, paint the picture.
Market views: 11 bankers speak
We interviewed bankers around the country and found many regional variations. While much can be said about trends in community bank CRE lending and administration of existing loans across the country, the regionality of what’s going on doesn’t come as a surprise to consultant Michelle Lucci. The Southeast, she says, has recognized the bad loans they have on the books and are working their way back. The Northeast has seen some write-offs, but overall is doing much better than other regions. Much of California resembles the Southeast. Other regions have their own variations on the CRE theme.
Here’s some of what we heard:
• Battling in the Florida sun. After a long period of quiet, commercial real estate has become “hyper-competitive again,” according to Charles Brown, chairman and CEO at Insignia Bank, Sarasota, Fla. “Owner-occupied commercial real estate loans are being priced below residential loans,” says Brown. “It’s a head scratcher right now.” Brown speculates that so many bankers have so much liquidity right now that some are ready to lend at ultra-skinny margins just to be doing something active. Indeed, Brown says the definition of “owner-occupied property” has been stretched quite far, as well, with even unusual properties like car washes qualifying.
Such enthusiasm worries Brown. “I’m concerned that the industry may be dipping too low on the rates,” he says. While he won’t compete on every loan—“you have to pick your battles”—he says he has his eye on one where the accompanying deposit relationship will be important to the $142.2 million-assets bank in the long term.
• Coastal competition. In California, Greg Patton, president and CEO of $80.5 million-assets Sierra Vista Bank, Folsom, sums up CRE conditions this way: “Things are becoming more stable—but I wouldn’t say ‘better’ yet.”
As for bankers, “what little CRE lending there is, the big banks are just giving it away,” Patton says. He’s heard of loans running as long as ten years on CRE at rates as low as 4.35%. “You just shake your head and wonder, ‘How could it be that good a risk?’,” says Patton. The few loans being made are owner-occupied structures, and many are financed under the Small Business Administration’s 504 program.
• New England multi-family. “It’s been ‘interesting’,” says Kevin McCarthy of Rhode Island’s CRE environment in the last couple of years. President and CEO of $453.5 million-assets Newport Bancorp, Inc., a mutual bank holding company, he says much of the bank’s CRE activity has comprised multi-family properties, which have stood the strains better than other CRE types. The company does some owner-occupied commercial buildings and some bed and breakfasts.
CRE activity has slowed considerably in the last few years; as a consequence, jump balls are common.
“There are some good deals out there,” says McCarthy, “but everybody tries to glom onto the few good deals, and the pricing has become extremely competitive. Anyone who has good cash flow and a good business going is in a strong position if they are looking to purchase or refinance.”
“A year ago, the confidence wasn’t there,” he explains, “but we seem to be seeing signs of more confidence now. It’s not business as usual, but it’s more than we’ve seen in a while.”
• New Jersey all hemmed in. CRE is stable, reports Frank Sorrentino, chairman and CEO, $729.5 million-assets North Jersey Community Bank, Englewood Cliffs. Sorrentino, who comes from a construction business background, says his area benefited during the commercial real estate boom since there is so little open land left. “We’re in a fairly well-developed part of the state,” Sorrentino says, “so there was less overbuilding, versus areas like Georgia and outside of Las Vegas. The land just doesn’t exist.”
“Values are still there and low rates have helped,” Sorrentino explains. However, he’s referring to stability, not prosperity.
“I hate to say there is going to be a new normal,” says Sorrentino, “because everyone is saying that. But I don’t think we’re going to see things return to the way they were.” He says builders have already adjusted, with much less speculative construction going on.
• Stressing stress tests in Michigan. CRE has stabilized, according to Art Johnson, chairman and CEO at United Bank of Michigan, Grand Rapids. However, he adds that “it’s stabilized at a pretty depressed point from the peak.”
Johnson says he’s learned the value in this period of both analyzing the bank’s portfolio for unrealized concentrations and performing CRE stress testing. These practices have helped $458 million-assets United’s management discover exposures it didn’t realize it had—such as a stronger concentration of loans involving the automotive business than initially believed.
Any return to “usual” hinges very much on the Federal Reserve, says Johnson. At present, business owners’ confidence isn’t driving much loan demand.
• Georgia on his mind. Amid the damage of the state’s past CRE and development boom, Dan Blanton says some competitors—mostly larger banks—are making ten-year CRE loans to the few solid borrowers who want such credit. “Area prices have leveled off,” says Blanton, president and CEO, Georgia Bank & Trust Company of Augusta, “but there’s not a lot of demand.”
“If a good deal comes up,” Blanton adds, “every bank in town will fight for it, and rates will be skinny. But there’s nothing else to do with our money.”
Blanton’s $1.6 billion-assets bank has held onto some deals by going out as far as five years, but the pressure on community banks to match the larger competitors has been strong. One factor that makes some deals easier to swallow is when fat deposits come along with the loan relationship. While liquidity is strong now, Blanton wants to build more such relationships for the future; in the near term, gaining deposits allows his bank to retire hot money such as brokered CDs.
• Reducing CRE concentrations in Utah. Leonell Castillo, president and CEO at American Bank of Commerce, Provo, notes that state-chartered institutions have chopped back tremendously CRE concentrations. “Utah was a huge CRE state,” says Castillo, “and there was a tremendous amount of speculation taking place.”
As a result, property values dropped significantly, according to Castillo. Commercial properties have fallen by as much as 50% over the last four years. Castillo says his $46.2 million-assets bank recently sold a group of residential lots at a 75% discount from their original value. Such price drops result from a growing inventory on the market, which he says includes properties FDIC is trying to move after taking over failed institutions.
Conditions have started to improve, but Castillo sees a hard slog ahead. “Utah is like many places in the U.S.,” he says. “It is going to take some time.”
• Housing land glut. In his West Virginia and western Maryland markets, Brian Thomas reports that values have been stable for some time. “We didn’t experience the bubble,” explains Thomas, president and CEO at Clear Mountain Bank, “so when the recession occurred, they didn’t have to drop as far either.”
One issue has been lots developed for residential housing, complete with streets and sidewalks. Thomas says a recent study indicated there’s a nearly decade-long supply in the market, a mountainous region that’s popular for second homes. But for lenders like $425.8 million-assets Clear Mountain, CRE loans associated with these properties are the ones most typically having trouble.
“Thankfully for us it’s a very small part of our portfolio,” says Thomas. Only two have deteriorated sufficiently to land in workout.
• Shrinking part of the portfolio. In Seguin, Texas, Mark Long says some CRE borrowers are expanding, but the level of such borrowing has fallen off from three or four years ago. While CRE represents the largest category of lending at his $109.8 million-assets First Commercial Bank, N.A., Long reports a falloff in both CRE and in interim residential construction loans for home builders.
However, he adds that there have been signs of some pickup lately.
• Condos made of dirt. Other trends also are intersecting those in CRE. Back in 2009, when ABA Banking Journal presented a cover story called “CRE Pain,” a major issue in some markets was appraisers’ tendency to mark down lots that had been intended for building subdivisions to their lowest use and price—farmland or, basically, just dirt. But now farmland prices have been rising, in some locales by leaps and bounds, ratcheting up as cash-rich farmers outbid each other to expand their farms.
At $923 million-assets Farmers and Merchants State Bank, Archbold, Ohio, CRE represents 40% of the bank’s portfolio. Paul Siebenmorgen, president and CEO, says of CRE that “we’re in a fairly slow market. It’s a weak market, a soft market.”
But, as its name suggests, the bank also does farm business, and the rising trend in farmland prices has Siebenmorgen concerned. “I look at some of this farm ground,” he says, “and I think of Miami condos.” The bank is asking for higher down payments as a result.
Round 2 coming?
What worries real estate professionals in all this is that the CRE troubles now leveling off aren’t the end of the bad times. Accenture’s Colette Prior points out that approximately $350 billion in commercial real estate debt will need to be refinanced over the next few years. Who in the banking industry and elsewhere will step up to refinance that debt is an open question, subject not only to the CRE markets and their appeal at any given time, but to world financial events.
Not all of this is a community bank problem. Lots of it involves large properties way out of their league. But many have financed atypical properties that aren’t a straightforward affair to other lenders, says Deloitte’s Tino Korologos. Examples include churches, nursing homes, and specialized structures such as bowling alleys.
“If no one goes for these asset types, who is going to refinance them?” and take out the original lender, asks Korologos. He predicts that loans done at the peak of the market—those stretched for in loftier times—will tend to be the ones that give bankers trouble down the road. Add to this the possibility that some lenders won’t be interested in CRE at the lower rates that will prevail over the next few years.
And further on, says Korologos, lenders must ask if a property will support the higher rates that will, inevitably, return.