Pressure Point

By Robert Stowe England

Banks' commercial realty portfolios are ballooning once again. Can new financing and risk management techniques help keep the bubble from bursting?

It's deja vu all over again – or is it? Bank commercial realty lending is mushrooming anew and regulators are, again, warning about overbuilt markets and overly relaxed underwriting standards. Bankers, pointing to an array of new ways of reducing loss exposure, are asserting, "It's different this time." Sound familiar?

It is, in fact, a well-established pattern in the banking industry. Banks predictably get caught up in real estate's speculative frenzies and just as predictably get hammered when overbuilt markets cool off. The most recent episode, which began in the mid-1980s and peaked in the early '90s, saddled banks all over the country with large write-downs and actually drove a few major institutions into regulatory receivership.

With this sobering history as a backdrop, banking's re-embrace of commercial realty lending should not be taken lightly. U.S. commercial banks racked up a 23.4% increase in construction and land development loans during the 12 months ended June 30, according to the Federal Deposit Insurance Corp. – rapid growth in anybody's book. Meanwhile, balance sheet concentrations of long-term commercial realty assets are distending to levels not seen in years. And FDIC research indicates a high potential for overbuilding in numerous markets, including Atlanta, Dallas and Las Vegas, especially if the economy slows.

Underwriting discipline and interest rate margins also seem to be slipping. A September 1999 examiner survey by Office of the Comptroller of the Currency indicated commercial realty underwriting standards had weakened for the fourth consecutive year, unlike other lending areas. In a separate study, the FDIC found that net interest margins in C&D lending had fallen close to, and in some cases below, those of the late '80s. "The question is, 'Are banks able to get enough return to compensate for the risk?'" says Steven K. Burton, author of the report.

There's also some uncertainty about the role being played by real estate investment trusts and commercial mortgage-backed securities, which are displacing traditional sources of long-term funding. REITs already have exhibited a pronounced tendency to restrict funding in adverse market conditions, raising a caution flag for banks depending on such vehicles to take their short-term construction loans off the books. As for CMBS funding, the federal regulatory agencies in December issued a joint warning – mostly directed at community banks – about accounting and risk management practices surrounding securitization, and they cautioned about "the liquidity risk associated with over-reliance on asset securitization as a funding source.

It doesn't help that institutions are having difficulty achieving sustainable revenue growth in other business sectors. But at this stage in the economic cycle, yielding to competitive pressures would be a grave mistake. With the current economic expansion getting long in the tooth (nearly nine years and counting), another damaging downturn ostensibly would not be far off.

On the other hand, the market's strengths should not be underestimated. FDIC statisticians say overall credit quality on bank commercial realty loans is exceptionally good right now. Certainly, many institutions remain keenly mindful of the perils they encountered last time around and are tempering their activities. And optimists contend the emergence of the REIT and CMBS markets has brought a new level of market discipline.

Are markets as overheated as they were in the late '80s and early '90s?" asks Kevin Blakely, group executive vice president for risk management at Cleveland-based KeyCorp. "I believe the answer is no. The market is more disciplined in this cycle than the last." Blakely's views can be considered representative because he's also chairman of Robert Morris Associates, the Philadelphia-based trade group that monitors credit risk at banks.

Still, if the industry is to avoid another crisis, it will be up to bankers to maintain discipline and take advantage of modern risk management techniques. Some institutions are funding smaller construction projects with shorter construction time frames, for example, achieving greater diversification. Sophisticated players are using computer models to perform portfolio stress tests, which help diagnose whether cash flows from rentals could continue to cover increases in borrowing costs should interest rates on variable rate loans rise. An added protection is scenario testing, where each project is subjected to various hypothetical interest rate environments to determine the impact on vacancy rates, cash flows and the cost of borrowing.

Banks are further using derivatives when segregating their loans for securitization. Such hedges are designed to offset the potential loss the bank might incur should rising interest rates drive down the value of a loan before it is sold in the secondary market. Banks are also asking borrowers to hedge their interest rate risk with an array of financial derivatives that provide offsetting income should interest rates rise above a given level, which would better protect debtors from losses in cash flow that might come from higher vacancies in a downturn. Finally, banks are focusing on alternative sources of payment and guarantees by other parties as a way of reducing credit risk.

Regulatory Concerns

Unquestionably, banks' balance sheet exposure to commercial real estate is large and growing. Banks held $541 billion of commercial realty credits on their books at midyear, an amount equaling 39% of the total market for commercial real estate mortgages. Insurance companies were a distant second, with a 15% market share, according to James F. Titus, director of real estate research at Donaldson Lufkin Jenrette.

And despite Wall Street's new liquidity engines, the balance sheet concentration of long-term commercial realty assets is nearing a new high -- 7.3% of total commercial bank assets at midyear, according to the FDIC, compared with the previous peak of 7.4% in March 1993 (the specific category is loans secured by non-farm, non-residential property). Absent securitization, banks' exposure would be much greater. Securitized commercial realty loans grew to $229 billion from $49 billion in 1994, according to Titus.

These proportions don't necessarily portend trouble. But regulators continue to come across evidence of weak practices and pricing. As part of a recent study comparing current commercial real estate lending practices with those of the late '80s, FDIC officials were troubled to learn that community banks in burgeoning markets are loading up on construction and development loans, although these concentrations are still below the levels seen in the late '80s.

Along with evidence of shrinking net interest margins in construction and development lending, the FDIC found instances of lax underwriting on loans to larger developers. Some borrowers had minimal equity at risk in their own projects; others none at all. This recalls the excesses of the '80s, when some banks and thrifts were lending 100% of the cost of building speculative office towers. The FDIC is further worried about overbuilding. In Dallas, for example, "the pipeline of projects being built is tremendous," Burton says. "That's why we're seeing that region's vacancy rate going up."

To lower the odds of a blowup, federal regulators are zeroing in on a few key areas of perceived deficiency. Dave Gibbons, the OCC's deputy comptroller for credit risk, is urging banks to do a better job of tracking exceptions to their established underwriting policies and practices for commercial real estate loans. The OCC is encouraging banks to list all loan exceptions and compute the volume of business represented by those exceptions, then evaluate the extent to which the exceptions cause higher risk for the portfolio. The OCC also wants to see strengthened risk management oversight. "Banks should be sure their credit risk control processes are adequately staffed and appropriately empowered to point out where risk is rising in these portfolios, and to tell managers what they need to hear," Gibbons says.

To be sure, the deficiencies uncovered by the regulators have not proved particularly damaging in today's environment of robust economic growth. But that could change if interest rates rise and the economy begins to slow down, as some now see happening. "There was a great run from 1992 to 1998, but now all indications are of a slowdown," DLJ's Titus says. The danger of a slowing economy is that it would aggravate rising vacancy rates and depress property values even as new developments reach the completion stage.

Financing Discipline

One major difference in the current commercial realty expansion is the role played by the public markets. Some executives strongly believe that the oversight accompanying Wall Street funding is, in fact, strict, and will help keep the market in check. "The capital markets have made an incredible difference in the way (commercial realty) money is lent," says Joe Tufariello, director of production in the New York office of Atlanta-based J. P. Mortgage Capital, Inc., a bank-owned conduit for commercial mortgage-backed securities.

The debt issuance market, for example, has seen a rapid rise in commercial mortgage-backed securities. This securitization process allows banks and other providers of interim construction financing to move finished projects off their balance sheets by pooling them into trusts that back special mortgage bonds sold to investors. By early December of 1999, CMBS issuance had hit $65 billion, down from a 1998 peak of $78 billion, but way ahead of the $5.7 billion issued in 1990, according to the Mortgage Bankers Association of America.

REITs, meanwhile, have emerged as major buyers of established and newly developed properties. Although they represent only about 10% of the owners of all commercial real estate, their penetration of some sectors is considerably higher. At year-end 1998, REITs owned 31% of all retail malls, 19% of hotels, and 13% of non-mall retail buildings, according to Prudential Real Estate Investors, which mines regulatory filings for its data. REITs' penetration of other markets was somewhat lower: 7.9% of apartments, 7.2% of offices and 6.6% of warehouses.

Lisa Sarajian, a managing director of Standard & Poor's in New York, says REITs help prevent overbuilding by virtue of their role as "the ultimate purchaser" of many properties under construction. REITs scrutinize their purchases carefully to be sure cash flows and values fall within established risk limits, a discipline fostered by investors, who demand full disclosure about properties owned by REITs. Thus, if REITs won't buy speculative properties, developers will be reluctant to build them.

The information compiled by these new intermediaries also benefits lenders. Kenneth Witken, managing director of the real estate finance group at Fleet Boston Corp., recalls how bankers once had to really dig to find demographic information and the prices of competing projects. Today, lenders can research the supply and demand for commercial real estate on a market-by-market basis, along with projections of net in-migration and its impact on overall building needs.

Perversely, however, the rapid growth of public funding vehicles such as REITs and the CMBS market has compounded competitive pressures by making more funds available. "There's much greater investor demand for loan-related assets than there is supply," says David Tibbals, managing director and head of commercial mortgage finance at New York-based Salomon Smith Barney Holdings Inc., which serves both as a commercial mortgage originator and a bond underwriter for mortgage-backed securities. The result of over-abundant capital is a weakening of lender discipline. "Construction lenders may be more aggressive, lending on a speculative basis, for instance, if they believe funding is readily available to 'take out' the C&D loan," says the FDIC's Burton.

Further clouding the picture are questions about volatility. In late 1998, for example, REITs dramatically pulled back from the market after global interest rate shocks and fears of overbuilding hurt their share prices. After capturing an estimated 35.5% share of commercial property acquisitions in 1998, REITs slid to an estimated 13.3% share in the first half of 1999, according to market samples compiled by Investments Trends Quarterly, which is published by the Commercial Investment Real Estate Institute. This underscores the point that long-term funding can quickly evaporate in times of stress, even when supplied by the most efficient of intermediaries.

And even when financing conduits are open, rate risk can still spoil the party. A bank retains exposure while credits are being aggregated into pools for securitization, a process that can take four months or more. Depending on the terms extended to the borrower, the lender can get caught short if interest rates spike. Loans already in the securitization conduit then must be sold into the market at a loss. Last year, some commercial mortgage companies got badly burnt during the global liquidity crisis sparked by Russia's default on its bonds. Some banks that owned conduits also felt the pain.

Competitive Pressures

While securitization is of growing importance, many observers are far more interested in what's happening on bank balance sheets. It is true that bank exposure to construction and development loans – the riskiest category of commercial realty financing – is down from prior peaks, both on an absolute and proportionate basis. The FDIC says C&D loans hit a peak concentration of 4.25% of total commercial bank assets in the third quarter of 1989; the midyear 1999 figure was 2.25%. Even so, the inventory is growing conspicuously. Meanwhile, the concentration of long-term commercial realty loans is nearing record levels.

This puts the focus squarely on bank underwriting and risk management practices. One hopeful trend is a shift away from collateral-based lending, which emphasizes current and projected market values of assets, as opposed to the cash flows and market forces that drive those values. Banks are placing far greater emphasis on project feasibility, an approach that assesses the impact of other competing projects; the quality of completed projected cash flows; and borrower cash equity requirements. This shift has helped limit funding availability for highly speculative ventures, according to the FDIC's Burton.

Banks have also limited their risk to some extent by shifting development to more dispersed suburban areas and to smaller construction projects with shorter construction time frames, Burton says. By diversifying their portfolios in this manner, banks decrease the chances that one or two big loans will go bad and impair their capital.

Another protective measure is stress testing, which measures how changes in interest rates can affect a given adjustable-rate loan. Some banks are doing scenario testing as well, where an entire portfolio or selected projects are subjected to various economic scenarios and wide interest rate swings to determine effects on vacancy rates, cash flows and the cost of borrowing. Banks are doing a better job of managing interest rate risk through derivatives, which hedge interest rates on a transaction-by-transaction basis. They are also asking borrowers to hedge their own interest rate risk to better protect against the cash flow losses that might come from higher vacancies in a downturn. Finally, banks are focusing on alternative sources of payment and guarantees by other parties as another risk-reduction tool.

Aggregate industry statistics paint a highly positive picture of the credit quality of commercial realty loans. Only 0.8% of commercial realty loanswere delinquent at U.S. commercial banks as of midyear 1999, according to the FDIC, compared with a frightful 6.2% peak during the third quarter of 1991. Chargeoff ratios are similarly encouraging. The 2.1% peak ratio during 1991's fourth quarter compares with a scintillant 0.05% ratio in 1999's second quarter.

There are not a lot of cowboys out there doing any project that comes along," says Blakely of Robert Morris, asserting that this is a distinct contrast from the 1980s, when "there was a lot of overbuilding by very aggressive S&Ls." Other monitors of bank lending risk agree. "Banks learned a lesson from the late '80s," says Jim Davis, president of Loan Pricing Corp., a New York-based database company that tracks loan market trends. "We don't see, for example, banks making construction financing loans to speculative projects, such as huge office towers with no tenants.

Will the new discipline exerted by public markets and lenders' own risk management techniques turn this real estate cycle into a virtuous one, i.e., one without substantial overbuilding? "It's too early to call for sure," says Jon Southard, chief economist at Torto Wheaton Research in Boston. While overbuilding is inevitable, it will take a down cycle to know for sure how much overbuilding actually occurred. Southard presumes, however, that the negative effects this time will be less severe than they were during the early '90s.

One thing is for sure: the real estate cycle, like death and taxes, will always be with us. And during the next downturn, the mistakes made today will be all too painfully clear. Indeed, bankers, in a philosophical moment, should remind themselves of an old adage in this business: "The best of loans are made in the worst of times and the worst of loans are made in the best of times.

Mr. England is a freelance writer based in Arlington, Virginia.

Copyright © 2003 by Banking Strategies, published by BAI.

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