Brian Mischel

The liquidity crisis further accentuated credit and term risk for banks. Currently, the credit and term risk associated with commercial real estate is of great concern, and the ultimate impact is uncertain. Many smaller banks hold significant lending portfolios in commercial real estate, and the ultimate impact of commercial real estate credit and term risk will fall disproportionately on smaller banks with higher exposure to commercial credits. Potential loan defaults and loan write-downs will more than likely increase with maturities of commercial real estate loans increasing in the coming years. Capital constraints, liquidity constraints and further regulation will continue to impact bank financing. However, banks are not the only parties affected by commercial real estate market instability.

As a result of the crisis, underwriting standards have become stricter, thus tightening credit markets. Banks that have experienced significant losses or have considerable exposure to commercial real estate losses may not be able to extend new loans to borrowers or renew existing loans. Borrowers may no longer qualify for loans or renewals under new underwriting standards, and refinancing a loan may prove to be difficult despite solid past performance or high property quality. Commercial real estate loan losses could jeopardize the stability of many banks, and obtaining or refinancing loans may prove to be difficult, thus contributing to extended weakness of the financial system.

Lag Between Residential & Commercial Real Estate Cycles

There are several reasons why the commercial real estate cycle lags behind its residential counterpart. Economic growth or contraction takes time to work its way through the economy to the point where it influences commercial space demand. Commercial leases are typically multiyear and rental income is maintained for the period of the lease, even if tenants’ actual space needs have decreased. For example, a retail store may have lagging sales for months or even years before the lease comes up for renewal and the store is able to secure a smaller location, thus paying less in rent. The decrease in revenue is experienced by the property owner months or even years after the event that caused the decrease. Unemployment, a lagging indicator itself, also takes some time to influence commercial space demand. Each lost job translates into lower retail spending and eventually an empty office or work station.

Credit Risk & Term Risk

Commercial real estate financing arrangements create credit risk and term risk for banks. Credit risk is the risk a borrower may not be able to pay interest and principal during the loan’s term. Credit risk can lead to defaults before maturity and generally occurs when cash flow from the property is insufficient to service the debt, as credit risk for banks remains uncertain for the future.

Real estate financing will face uncertain term risk exposure. Term risk (or refinancing risk) is the risk a borrower may not be able to refinance when the loan term ends. The typical term of a commercial real estate loan is three to 10 years. The amortization schedule is often longer than the loan term, usually 30 years with a balloon payment for the outstanding principal due at maturity. As a result, future refinancing is assumed during underwriting of the original loan.

Commercial borrowers usually refinance at the end of their loan term, but many with loans reaching maturity have faced difficulty refinancing due to stricter underwriting standards. Loans that are “under water” have required additional investment the borrower often cannot afford. In the event a borrower cannot refinance, banks must determine how to recover their investment and minimize loss. This may include restructuring the credit, extending the term, foreclosure or liquidation. Term risk may ultimately prove to be an escalating problem, particularly in the next several years. The number of loans that cannot be refinanced at maturity is steadily increasing. Commercial real estate loan maturities are expected to increase significantly from 2010-13. The following graph illustrates the historical dollar value of maturities and projected increases through 2013.

Source: Federal Reserve, Foresight Analytics

Loans maturing in this time period were originated during the height of the real estate bubble. Commercial real estate values inflated to unsustainable levels, and a significant number of loans were made during this time. Both credit and term risk increase as property values continue to fall and loan-to-value (LTV) ratios continue to rise. As a result, losses will likely continue in the next few years, and the commercial real estate market will likely continue to deteriorate.

The Effect of Interest Rates

Net interest margin (NIM) remains one of the principal elements of bank net cash flows and earnings. NIM is a performance metric that examines the difference between interest and dividends earned on interest‐bearing assets and interest paid to depositors and other creditors, expressed as a percentage of average earning assets. NIM for community banks has slightly recovered in recent years and maintained relatively consistent levels due to historically low interest rates (see graph below).

Source: FDIC

While historically low interest rates have allowed the NIM for banks to somewhat stabilize, rate increases would affect more than liability-sensitive banks. Most commercial loan terms are at variable interest rates and would reprice with a rise in interest rates. Such an increase would adversely affect many borrowers’ ability to service debt due to the underlying properties not being excessively profitable or cash flow positive. Delinquency rates and bank losses could significantly increase with a rise in interest rates.

Commercial Real Estate Values

When property values were increasing before their peak in 2007, properties could often be sold for more than the outstanding mortgage. This is not possible in many instances today. Tenants’ decreased space needs have led to declining cash flows, resulting in increased vacancy rates and decreased rental income. There appears to be an oversupply of properties and an undersupply of prospective tenants and purchasers. As a result of these and other factors, the value of commercial real estate has declined. Declining commercial real estate values have caused LTV ratios to rise. A higher LTV ratio makes it more difficult for a borrower to refinance, regardless of the strength of the original financing, the quality of the property or loan performance. Current commercial real estate prices also are in a state of flux due to limited market comparables and volatile cash flow projections.

Delinquency Rates

The extent of ultimate commercial real estate losses for banks cannot be determined at this point. The increase in commercial real estate loans 30 days or more past due, as well as those in nonaccrual status for all domestic commercial banks (see graph below), suggests performance will continue to deteriorate.

Source: Federal Reserve

Delinquency rate increases will translate into more loan defaults and, ultimately, bank losses. Although delinquencies are not increasing as rapidly as several years ago, they are not decreasing. Additional significant loan losses resulting from commercial real estate loans and eventual failure of some small and regional banks appears unavoidable.

New CRE Regulation Likely on the Way

Significant CRE concentrations, particularly in construction and development lending, in economic downturns has been a leading cause of problem banks and bank failures. Bank regulators expressed serious concern in 2006 about the commercial real estate market. Regulatory guidance was issued advising banks to limit their concentration in CRE loans to 300 percent of total capital and concentrations in land, land development and construction loans to 100 percent of capital. This guidance was necessary but has not worked as well as originally anticipated, and the extent of the issues were greater than first expected. In 2009, regulators issued supervisory guidance to assist examiners in evaluating banks’ efforts to renew or restructure loans to creditworthy CRE borrowers. The guidance addressed supervisory expectations for a bank’s risk management elements in such situations. Further regulation regarding commercial real estate lending policies is likely imminent. Comptroller of the Currency John Dugan indicated policymakers should consider a range of options including increased capital requirements, a more granular approach to defining concentrations (since not all CRE is the same), minimum underwriting standards, more stringent requirements for concentrations supported by substantial amounts of noncore funding or some combination of the above. Any course of action will likely be phased, taking into account the current activities of all banks.

How Borrowers Can Work with Their Banks

Many commercial real estate borrowers will seek additional borrowing capacity or need to refinance or restructure loans. Borrowers should be aware of recent guidance issued by bank regulators on commercial real estate loan modifications and restructurings. Below are several items borrowers should concentrate on to better position themselves before negotiating their additional borrowing or refinancing needs.

• Communication – Borrowers should communicate with their bank early and often. Communicating a problem early allows for more time and options to find a solution that benefits all parties. The bank can be the borrower’s best ally when times get tough.
• Cash flow – A profitable business can fail or go bankrupt without sufficient cash flow, while an unprofitable business can continue operations if it has sufficient cash to pay creditors. Banks are most concerned with whether a borrower can generate the cash needed to repay the loan. Banks want to see reliable and accurate cash flow information on a timely basis. If cash flow is currently insufficient to repay the loan, the bank will want to see a feasible plan to improve cash flow that can be executed.
• Restructure the balance sheet – Restructuring a balance sheet may allow a borrower to improve cash flow and provide long-term growth opportunities. There are several ways to restructure a balance sheet without raising additional capital. For example, shareholder debt could be converted into equity, thus considerably improving cash flow. Borrowers also could negotiate a modification or restructuring of existing debt at more favorable terms.
• Loan modification or restructuring opportunities – Interest rates remain at historically low levels, and regulators have recently issued guidance regarding the modification and restructuring of commercial real estate loans. Bank regulators issued a policy statement in 2009 to produce consistency in supervision and make credit available to sound borrowers. The guidance stated renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. This is an excellent opportunity for healthy borrowers to take advantage of low interest rates and a regulatory environment that has eased bank requirements for adverse classification.
• Evaluate your primary lenders – Borrowers should evaluate their primary lenders to protect themselves from term risk exposure. Many banks are facing increased problem assets, liquidity issues and regulatory pressure. In some cases, banks won’t—or can’t—refinance particular credits based on their financial situation. There is information readily available for borrowers to monitor the performance of banks. The Uniform Bank Performance Report (UBPR) examines liquidity, adequacy of capital, earnings and other factors that could damage bank stability. The UBPR is an individual analysis of banks that includes extensive comparisons to peer group performance. A borrower should be familiar with the financial status and wherewithal of their primary lender and other potential lenders to ensure their future financing needs are met. Click here to use this analytical tool, which can be used to evaluate any bank.

From the prospective of both banks and borrowers, commercial real estate loans remain uncertain. If borrowers are unable to refinance, banks will have to decide whether to refinance, restructure or extend a credit or foreclose. Banks must determine which course of action minimizes their losses and exposure. Borrowers must have an open dialogue with their banks and plan ahead to put themselves in the best position to ensure their future financing needs are met. Until businesses begin to hire new employees and expand their operations, it remains uncertain if the commercial real estate loan market will achieve a significant recovery. Banks and borrowers will likely endure further losses.

Contact your BKD advisor with questions about commercial real estate lending. We are ready to work alongside you in this challenging and unique environment.