Positive Prognosis

Banking sector produces fewer distressed real estate assets.

Banking Sector Produces Fewer Distressed Real Estate Assets

By Keat Foong, Finance Editor

Finance artKiser Group is a boutique investment sales broker that engages in the disposition of multi-family, mixed-use, land and other types of investment assets, with a focus on the Chicagoland middle market. Most of the middle-market distressed assets (averaging $5 million in size) that cross the company’s threshold today are bank owned, and their numbers are falling.

One reason for the decreased inventory of distressed assets is that the majority of such assets have moved off banks’ balance sheets, according to Kiser Group principal Lee Kiser.

“There are still a lot of distressed properties, though not nearly the volume we have seen in the past,” said Kiser. About 35 percent of the company’s investment sales transactions today can be labeled “distressed assets.” It began dropping last year, when 45 percent of the volume was composed of distressed assets, he said. The year before, that number totaled 70 percent, while in 2010 it was 80 percent.

Indeed, investors looking to banks as a source of distressed assets may want to take note: The health of banks and bank loans continues to improve, and there are simply fewer defaulted properties that may potentially be pumped into the investment sales market.

Gregg Gerken, senior vice president & head of U.S. commercial real estate lending at TD Bank, affirmed this is taking place in his portfolio, too. “As the economy improves, the overall health of the market has improved, and as a result, the trends in our portfolio are positive.”

The national numbers likewise bear out this trend. Bank delinquency rates overall have fallen in the past two-and-a-half years, noted Mark Fitzgerald, senior capital markets strategist at Property and Portfolio Research/Co-Star. According to PPR/CoStar, delinquencies on construction loans held by banks peaked at 19.6 percent in the first quarter of 2010, and have since dropped to 8.4 percent. For non-residential, non-farm, commercial real estate loans, the delinquency rate has dropped from a high of 5.6 percent during the recession to 3.35 percent in the first quarter. As for bank loans secured by multi-family housing, the delinquency rate is even lower: currently 1.9 percent, compared to just under 6 percent during the Great Recession.

To place the data in perspective, delinquency rates for CMBS loans are a multiple of those for banks, said Fitzgerald. The special servicing rate for CMBS loans is currently about 10.3 percent, down from 13.5 percent at the peak. It has remained in double digits for the past three years, he said. (While falling in the case of multi-family and retail loans, delinquencies have actually increased in CMBS loans secured by office, industrial and retail property.)

Accordingly, the sales of non-performing bank assets have dropped. “PPR’s analysis of the data suggests that fewer bank-owned distressed properties are coming onto the market,” said Steve Miller, director of U.S. capital markets, debt and risk management research for PPR/CoStar. There are about $20 billion in REO commercial real estate loans outstanding as of the first quarter, versus an average of $30 billion in 2010 and 2011.

Recovering property values, as well as lower interest rates, are also allowing more underwater properties to survive, and thereby contributing to improvements in the overall health of outstanding bank loans. “Certainly, a rising tide lifts all boats. The property markets have improved, and interest rates are low,” said Dan Gorczycki, managing director at the investment advisor Savills. The lower interest-rate environment is providing relief on periodic loan payment, explained PPR/CoStar’s Miller. “Relative to 2007 whole-loan lending rates, comparable payments in 2013 are likely to be between 25 to 40 percent lower.”

Gorczycki noted, however, that the improving health of loans is not necessarily a reflection of better real estate fundamentals. “Vacancies are still up, unemployment is still high, and there is negative absorption” in a lot of markets. “New York City and Washington, D.C., for example, are booming like never before, but markets such as Dayton, Ohio, have not improved at all,” and conditions may even have worsened at the office-tenant level in some markets, he said.

As the volume of troubled bank loans has declined, banks are actually in a better position not to grant extensions on underwater loans today, as they are in a stronger financial position. For the first time since 2008, in May Moody’s raised its rating of the U.S. banking system to “stable” from “negative.”

“Sustained GDP growth and improving employment conditions will help banks protect their now-stronger balance sheets,” Sean Jones, Moody’s associate managing director and co-author of the report, said in a statement. “In addition, after another year of reducing credit-related costs and restoring capital, U.S. banks are now even better positioned to face any future economic downturn.”

As banks are better able to absorb losses, they are more likely to move to take the real estate assets back, explain experts. With their balance sheet in a strong position today, banks no longer have that incentive to “extend and pretend.” And they will not hesitate to foreclose, depending on the circumstances. “’Extend and pretend’ is definitely not the trend we are seeing with the lenders we deal with,” agreed Abraham Bergman, managing partner at Eastern Consolidated.

Gorczycki explained that during the recession, banks had an overriding motivation to keep the loan: If they sold the loan or property, they would have had to write down its value on their books. “The banks engaged in ‘extend and pretend’ as they did not want to have to deal with (the issue of writing down the loans) unless they had to. If you could afford to cut the interest rate, defer payment and keep the loan as a performing loan, you did not have to take a big write-down.”

The fact of the matter, however, is that even with improving market conditions and economies, generally lower allowable loan-to-value ratios mean that loans that benefit from extend and pretend will still require capital infusion. Problem loans are placed in two buckets, Gorczycki commented: Banks will give preferential treatment to borrowers if the property is located in a strong market and if the borrower has a strong net worth and can place additional equity into the deal. However, in the case of “free ride” borrowers who are contentious or who will not inject additional equity or if the property is located in a weak market, the banks will act to take back the property. Much also depends on the borrower, said Gorczycki: “Is the borrower someone they want to do business with?”

The extent to which banks are willing to keep underwater loans is also affected by bank regulations. Regulators did not force banks to aggressively mark down to market the value of existing underwater loans that were held on the books. If they had forced write-downs, it would not have motivated the banks to extend the loans, since their values would have been reduced, anyway.

Bergman agreed that banks may be more unforgiving in foreclosing than they may have been during the recession, but he is also of the view that loan restructuring and discounted payoffs could be considered by banks before foreclosure. “The banks’ first approach today is to have an open line of communication with the borrower. If they are able to create that dialogue, they will proceed with loan restructuring—and if that isn’t feasible, discounted payoff. However, if the borrower is not cooperative and isn’t willing to work with the lender, the lender will immediately move to foreclosure.”

Kiser pointed out that whether a bank is likely to engage in a short sale or foreclosure in a particular case has to do with whether it has a loss share agreement with the FDIC. If the FDIC is taking a portion of losses that result from the sale of the asset, the FDIC usually will prohibit a short sale or note sale and will probably require foreclosure in order to ensure highest recovery value.

Be that as it may, Miller suggested that the good news is that in the low-interest-rate environment, loan modifications can provide powerful relief to the borrower. However, he noted that accounting rules and regulatory guidance can limit the amount of interest-rate relief given to borrowers by banks.

THis article appeared in the July issue of Commercial Property Executive magazine.