Why Bankers Are Wary of Office, Hotel Loans — and Bullish on Manufacturing

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Houston's once-red-hot economy has cooled considerably since the days when oil was selling for more than $100 a barrel and that has forced commercial real estate lender Jody Proler to be far more selective when pursuing new business.

If any type of deal related to an office building crosses his desk, Proler, who works in the Houston office of Choudrant, La.-based Origin Bank, wants nothing to do with it. He's similarly skittish about any deals involving the construction, purchase or refinancing of a hotel property.

"Houston was clearly oversupplied in Class A office space. There were energy companies that leased out space and literally never put a single person in the building," said Proler. The $3.9 billion-asset Origin has a "long history" in financing hotels, but Proler said that any new hotel loans it makes "will be very limited in size and scope."

Slowing economies in energy hotbeds like Houston and North Dakota help explain why delinquency rates on loans tied to office and hotel properties are on the rise.

According to Trepp, a New York-based provider of securities and investment data, the total value of delinquent commercial mortgage-backed securities that were secured by loans on office buildings climbed nearly 6% in 2016 when compared with a year earlier, to $8.7 billion. The total value of delinquent CMBS secured by hotels rose 12.1% to $2.3 billion in the same period.

But weakness in the energy sector explains only part of the increase in problem commercial real estate loans.

A surge in new construction has led to an oversupply of office space in several urban markets, including Washington, D.C. Also, many CMBS issuances that are currently delinquent are backed by loans in which banks overvalued the properties in the first place, said Matthew Anderson, managing director at Trepp. Many of those loans were originated before the financial crisis, he said.

"You may have thought we were done with the excesses of the past, but we still have loans from the previous peak still causing reverberations in the market today," Anderson said.

Many CRE loans from the pre-crisis era went delinquent last year and Anderson expects the trend to continue to this year.

The rate of CMBS delinquencies is not a perfect measure of the health of CRE lending, Anderson acknowledged. Properties that underlie a CMBS issuance may have problems unrelated to the local economy or to its specific property type. And the original lender is typically off the hook, because it long ago sold and securitized the loan. But, in general, CMBS delinquency rates do provide a good sense of which sectors could become trouble spots.

"Delinquencies can be a lagging indicator, but they do reflect the conditions of underwriting at the time of origination," Anderson said.

Consider the example of malls. Trends in brick-and-mortar retailing have moved away from enclosed malls located in the far suburbs, in favor of pedestrian-friendly shopping centers. Not surprisingly, one of the largest CMBS delinquencies in 2016 was a $240 million loan, called the Westfield Centro Portfolio, tied to a group of regional malls in California, Colorado, Connecticut, Missouri and Ohio. In a research note in October, Morningstar said that investors have lost close to $2.9 billion on liquidations of shopping mall loans since 2010.

"The run-of-the-mill suburban mall is not headed in the right direction," said Joseph Orefice, the head of commercial real estate lending at the $23 billion-asset Investors Bancorp in Short Hills, N.J. The only types of malls that are considered viable are those with an entertainment component, such as theme-park rides, he said.

Overall, though, retail is holding up generally well. Delinquent CMBS tied to retail loans fell 3% in 2016 from a year earlier, to $8.7 billion.

Look no further than North Dakota to understand how CMBS delinquencies can mirror trouble spots, Anderson said. The state's economy started to boom in 2006 when hydraulic fracturing, or fracking, in the Bakken shale region took off. Developers scrambled to build hotels and apartment buildings to deal with the influx of workers.

But a sharp fall in oil and gas prices has weakened North Dakota's economy and, as a result, vacancy rates at all those hotels and apartment buildings have soared, depressing their value. About two-dozen CMBS issuances based on North Dakota projects were in delinquency status in December 2016, according to Trepp. They include a $27 million loan for the States Addition Apartment project in Dickinson, N.D.; a $12 million loan for a Hyatt House hotel in Minot, N.D.; and a $7 million loan for a Hampton Inn located in Williston, N.D.

The Houston-area economy has also struggled because of the energy sector's downturn, and scores of nearly empty office buildings now dot the landscape, Proler said. There were 19 CMBS issuances on Houston-area properties in delinquency status in December, including a $14 million loan for the Northwest Crossing office building in Houston.

Instead of office buildings or hotels, Proler wants to find industrial projects. Origin on Thursday announced that it will provide financing to Archway Properties for its development of a Mitsubishi Caterpillar Forklift America distribution warehouse in Conroe, Texas. Origin declined to disclose the loan amount.

The Mitsubishi Caterpillar project has a number of characteristics that Proler thinks make it a good bet, the most notable being that multiple industries use forklifts. Also, Mitsubishi and Caterpillar, which formed a joint venture to build forklifts in the early 1990s, are respected global companies that have been involved in the manufacturing of heavy equipment for decades.

"Great developer, great contractor, great tenant, that pretty much equals a good credit risk," Proler said.

Industrial properties, as a whole, showed improvement in 2016, in terms of delinquency rates. The total dollar value of CMBS delinquencies tied to industrial properties fell 7.3% to $1.2 billion from a year earlier.

Investors Bank wants to do more industrial lending, Orefice said, "but it's very competitive and it's supply-constrained. We're very bullish on it, but there's not a lot of open spaces left in New Jersey and New York."

In addition to hotels and office buildings, mixed-use developments may also be a problem area for CRE loan delinquencies in 2017 and beyond, said Jay Pelham, president at the $3 billion-asset TotalBank in Miami.

Developments that include a combination of retail, apartments and office space, saw a spike in delinquent loans last year; the total value of delinquent mixed-use CMBS rose 4.6% to $1.2 billion. The largest delinquent mixed-use CMBS in 2016 was a $100 million loan for the City Place development in West Palm Beach, Fla.

Pelham explained why he is wary of mixed-use projects.

"It's the tenant turnover that kills you on these [mixed-use] projects," Pelham said. "You are constantly having to pay for improvements to the space to get the tenants to renew their leases."

Instead of mixed-use, TotalBank will focus its CRE lending on retail projects that already have committed tenants, as well as apartment or condominium buildings, Pelham said. His lenders will also prioritize projects that are located in stable areas.

"If it's located near the urban core, or the beach, or a university, as long as there's something that's a permanent draw there, it should be OK," Pelham said. "If it's out in the middle of nowhere, those are the ones I'd be careful with."

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