Commercial Real Estate Exposure Catches Banks in Economic Downdraft

Commercial Real Estate Exposure Catches Banks in Economic Downdraft

Banks Report Deterioration in Nonresidential Loan Portfolios, Tighten Purse Strings

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THE OTHER SHOE HAS DROPPED.

Banks began issuing their fourth quarter reports this week and a potential major trend appears to be the negative effect deteriorating business conditions are beginning to have on the credit quality of their commercial real estate loan portfolios.

In addition, banks are reporting they expect the credit quality of their portfolios will only continue to worsen. Not surprisingly, bankers also noted that the overall demand for loans has declined and so has the credit quality of prospective borrowers.

Their response has been to tighten lending criteria and/or focus primarily on the most creditworthy clients. “We are working hard to minimize risk and ultimate losses in Regions’ loan portfolio, nonetheless I would expect 2009 to be another difficult year,” Dowd Ritter, president and CEO of Regions Financial Corp. said this week in his earnings conference call.

“Provisioning and nonperforming assets will continue to be elevated and the levels will depend on the depth and length of the economic downturn and its effect in particular on housing, commercial real estate, and consumers’ balance sheets.”

“Problems continue to be centered in our homebuilder, Florida, home equity, second lien, and condominium portfolios,” he said. “However, as unemployment rises, risks beyond these segments are building, especially in commercial real estate categories such as retail properties.”

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Greg Smith, senior vice president and CFO of Marshall & Ilsley Corp. said they “continue to see softness in construction and development activity. This has translated into significant declines in new construction in all of our markets, with our Arizona and Florida markets most impacted, and less investor activity in new construction projects, with multifamily and medical office being the least impacted.”

“Retail has softened as many retailers have cut back expansion plans,” Smith continued. “Office is in relative balance in most of our markets, although dramatic job losses could impact this segment in 2009. Hospitality softened with the economy in the second half of 2008 and is expected to continue to soften as the economy contracts.”

First Defiance Financial Corp. chairman, president and CEO, Bill Small, told investors: “One area that we are a little more concerned about and have kind of put a lid on lending is into the residential rental properties, both single-family rentals and apartments. That’s an area we have seen some increased delinquencies and so we pretty much put a cap on lending in that particular area.”

“We keep reading that the next shoe to drop is retail and we are trying to get out in front of that,” Small said. “We’ve quantified what we’ve got in those industries and we are looking at individual credits on those industries to try to get the interim financials, and to the extent we can rent rolls, to get a better handle on how those particular properties are doing.”

Hadley Robbins, executive vice president and chief credit officer of West Coast Bancorp in Oregon, said: “We expect the current economic climate to have a negative impact on commercial properties, especially commercial properties and sectors of the market most exposed to cutbacks in spending by consumers and corporations.”

“For example,” Robbins added, “retail strip centers and shopping malls, office buildings, wholesale distribution, and hotel properties. Accordingly, we have significantly curtailed our origination activity for commercial construction, particularly in non-owner investor properties.”

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West Coast Bancorp, along with other financial institutions, also said the pipeline of business is on the decline, which is indicative of general economic weakness but also of the banks’ attempts to control risk-weighted asset growth. The banks have also started to be more proactive in dealing with their other real estate owned properties, i.e. properties that they have taken control of when a loan has defaulted.

Marshall & Ilsley’s Smith said their REO increased this quarter to $321 million, which is up from $267 million in the prior quarter. The largest REO property was an $11.5 million Midwest-based multifamily property. It had three additional commercial properties valued at more than $5 million.

“We continue to expect that REO balances will increase going forward and view this as a natural progression as we gain control of projects and move toward ultimate resolutions,” Smith said. “We will continue to aggressively manage our REO balances.”

Robert Kaminski, executive vice president and COO of Mercantile Bank Corp., indicated that banks are having some success at moving their REO assets, but that it is really property specific. “I think from a residential real estate standpoint I think that continues to be a challenge for the entire market,” Kaminski said. “From a commercial real estate standpoint it’s really property specific as you have properties that buyers may find attractive. Those prices are fairly stable and surprisingly so.” “There are those that may not be so attractive reflective in the lack of buyers,” Kaminski added. “So it really is property specific on the commercial side, residential real estate is probably the biggest challenge in terms of deterioration of prices regarding that segment of the real estate portfolio.”

The cyclical, Catch-22 nature of this recession is also evident from the recent bank reports: banks continue to see economic activity weaken across the country, as such, banks continue to avoid taking on more risks, which in turns creates another barrier to activity, and the market weakens further.

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Anders Giltvedt, executive vice president and CFO West Coast Bancorp, indicated that phenomenon is likely to continue. “In terms of our outlook for 2009, it’s obviously very difficult at this stage to provide a lot of color, but we certainly expect to maintain a defensive position,” Giltvedt said. “While we do have the capabilities and capacity to grow, we believe it’s prudent to stay focused on managing the portfolio and its credit issues at this point.” “The other important variable is how the non-residential construction portfolio representing 90% of total loans will hold up in a sustained weak economy,” Giltvedt said. “A modest loan production for the time being and a shift of non-accrual two-step and other residential construction loans into OREO, we anticipate that loan portfolio will continue to contract in the first half of 2009.”

This story is excerpted from the Watch List Newsletter.

The Watch List Newsletter is a powerful one-two-combination of both top-down macro analysis and bottom up micro real estate news, as well as valuable leads about companies contracting, future space availability and distressed property and loan investment opportunities. The Watch List Newsletter also includes all of this week’s Closures & Layoffs, plus bonus news items not found in these columns or the CoStar Group web news pages.

Written by Mark Heschmeyer

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