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Red Flag on CRE Riskiness

New York-The shorter the maturity, the smaller the risk - that's supposedly the rule of thumb in lending.

But credit crunches have a way of proving exceptions to such rules, and if Deutsche Bank Securities Inc. analyst Richard Parkus is right, banks holding commercial real estate mortgages are on the cusp of a major problem.

Mr. Parkus, who specializes in loans that have been pooled into commercial mortgage-backed securities, sees the CMBS market as stuffed with loans of increasingly shaky quality made from 2005 to 2007. Two-thirds of CMBS loans maturing over the next decade will fail to qualify for refinancing without big equity infusions - on the order of $100 billion - from borrowers, he says. Sobering as his forecast is, Mr. Parkus has even graver concerns about commercial mortgages held by banks rather than CMBS investors.

His reasoning? Banks tend to make loans with shorter maturities than the 10-year mortgages commonly found in the CMBS market. From now until 2013, the bulk of maturing loans made in the go-go years will be the ones held in bank portfolios, as opposed to CMBS or insurance company portfolios. That means banks won't have time on their side to await an economic rebound that helps troubled borrowers roll over debt and ensures enough credit for qualified borrowers to refinance.

The state of commercial real estate loans held by banks "is at least as risky and in our view probably significantly riskier" than that of repackaged loans distributed through the CMBS market, Mr. Parkus testified before a recent government-appointed panel assessing the impact of economic stabilization efforts. "Most of these loans were originated at the peak of the market and they're coming up for refinancing at the trough of the market."

More than $168 billion of the $204 billion in commercial mortgages coming due this year are held by banks and thrifts, dwarfing the $19.1 billion maturing in the CMBS market and the $16.8 billion of maturing loans on the books at insurance companies, according to Mr. Parkus.

Another problem for banks is that they often were the lender of choice for transitional projects. A loan made against an office building undergoing renovations, for example, most likely was based on the cash flows expected once the office space was re-leased, Mr. Parkus said. As the commercial real estate market weakens, those kinds of loans look increasingly risky.

But banks have at least one important advantage over the servicers involved in the CMBS market when it comes to working out problem loans: they tend to know their customers.

"While we do have more maturity risk, we also have the ability to sit down with our borrowers and talk through how we will get through the problem," said M&T Bank Corp.'s Kevin Pearson, who also testified at the Congressional Oversight Panel hearing in New York. "It's basic blocking and tackling. Banks can do that," he said, while borrowers whose mortgages were sold into the CMBS market sometimes find it hard just to get their servicers on the line, similar to what happened in the market for residential mortgage-backed securities.

Mr. Pearson, an executive vice president and the New York metro area head for M&T, said the Buffalo company kept its commercial real estate portfolio contained in recent years while many of the loans that the industry made from 2005 through 2007 "didn't make sense." But banks that find themselves ruing their commercial lending decisions often have options such as exercising five-year extensions on five-year loans to help mitigate defaults, he said.

According to Federal Deposit Insurance Corp. data, banks have about $1 trillion of commercial real estate loans on their books, an amount equal to about half of all outstanding commercial mortgages maturing sometime between now and 2018. Banks also are keeping a watchful eye on construction loans - a category that Mr. Parkus describes as "highly combustible" - and loans for multifamily residential properties.

In addition to maturity extensions - a strategy that Mr. Parkus says would only delay the inevitable for cash-crunched borrowers - banks are looking at many options.

Principal paydowns, increased collateral requirements, cross-collateralization for multiple loans and the offer of loan guarantors are among those that Paul Berry, a Houston real estate and banking lawyer of counsel to Diamond McCarthy LLP, has been examining for clients involved in debt restructurings. Berry also has been involved in the repurposing of property. In one, a general office condo was turned into a rental property focusing on health-care-related tenants.

But sometimes, particularly in a market where appraisal values plunged, there is no alternative, and a loan gets called or foreclosure efforts begin. When a troubled loan split among several banks, Mr. Berry said, "you would see amazingly different attitudes ... you have to look at their capital position to know what's going to motivate the banks to restructure."

The looming crisis in commercial real estate threatens to be far worse than the one that devastated areas including Texas and the Northeast in the early 1990s, Mr. Berry said. For starters, the trouble appears to touch all regions. There has also been a sharp increase in commercial development over the past two decades, meaning that even if the default rate this go-round is similar, the dollar figures at risk will be far larger.

Mr. Berry, who has worked with lenders and borrowers, said it will be critical for banks to put together proven or, at the very least, well-trained restructuring teams. "Restructurings are a totally different creature from making loans," Mr. Berry said.

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