Article: Commercial Squeeze

Commercial Squeeze

• Date:November 12, 2009
• Source:Business Lexington - www.bizlex.com
• Authors:Tom Martin & Susan Baniak

Lexington, KY — The national commercial real estate market bubble has been deflating steadily for almost three years with values down approximately 40 percent from 2007 highs.

While even in a continuing bearish economy, Lexington is experiencing more development activity than many, if not most, other mid-sized to major American cities, the Bluegrass is not immune to worrisome market forces in commercial real estate.

It's the same in Lexington as it is nationally," said Tim Haymaker, owner of Haymaker Development Company. "You have two different dynamics. You have people who are trying to bail out and are lowering their prices. At the same time, the whole myriad of lenders are pressured by the banking system to have more equity in a deal."

The result has been a tight cash pinch for many commercial real estate developers, according to Haymaker, especially in light of what he sees as the overdevelopment of some market segments in Central Kentucky. Industries previously served by one or two local suppliers have seen national retailers enter the market in a big way, and often with multiple locations, Haymaker said.

"Sometimes you just wind up taking business away from yourself," Haymaker said.

"We've got a perfect storm coming," said Bob Cole, president and principal broker of the Coleman Group. Nationally, Cole sees trouble brewing on the horizon for commercial real estate similar to that experienced in recent years by the residential market. Non-recourse lenders, including life insurance companies and Wall Street lenders, are sitting on trillions of dollars in loan deals made with five- or ten-year termination dates that are set to come due in 2010 and 2011, Cole said. At the same time, he said, banks are still being very selective and cautious about commercial real estate lending.

"Because of the skittishness in the market, they're not convinced that we've turned the corner," Cole said.

Is a turnaround on the horizon? Not for the short term, according to survey responses gathered by The Real Estate Roundtable. Those results show U.S. property executives rate "current conditions" at 56. The ideal is 100, and if achieved, would mean that those executives view present conditions as a significant improvement over a year ago and predict "much better" conditions one year from now. Of the more than 100 commercial real estate executives surveyed, 77 percent said property values are lower than a year ago. While an improvement from the 93 percent response recorded in the previous quarter, the outlook remains far from optimistic, with 71 percent of the respondents seeing no change or continued erosion in values in the next 12 months.

On the national scene, many borrowers have already been struggling to meet monthly payments. According to Trepp, the New York-based provider of Commercial Mortgage-Backed Securities (CMBS) and commercial real estate information, analytics and technology, the delinquency rate of securitized commercial real estate loans hit 4.8 percent in October, dwarfing the 0.77 rate a year earlier.

"That doesn't shock me. That market has pretty much dried up, locally, right now," said Jamie Schrader, owner of Schrader Commercial Properties.

According to Schrader, commercial real estate deals are still being made, but the approach has become considerably more conservative.

"I am seeing lending occurring on smaller transactions – $3 million and down – if people have good credit history and a well demonstrated revenue stream from the project," Schrader said. "In today's market, I don't see too much speculative building going on or much interest in purchasing properties if there is not an existing income stream."

The dubiety of the economy's direction and the availability of loan money has resulted in hesitancy on the part of both local and national commercial real estate developers, Schrader said.

"In years past, borrowers generally had a feel or a comfort level of knowing what the banks would probably do if they came to the banks with a loan request – the probability that it would be approved," Schrader said. "What's going on now is there is uncertainty as to whether the bank will lend you money and under what terms. Borrowers are not as confident, and that impacts how they operate."

Although local real estate developers believe loan money for commercial real estate projects has become less available, some local banks report an increase in the amount of commercial real estate loans they have been processing. According to Central Bank President Luther Deaton, commercial real estate loans at his institution in Lexington were up nine percent as of September 30, and overall, they increased three percent in the combined Louisville, Lexington and northern Kentucky area.

In addition, according to the FDIC's Statistics on Depository Institutions report, the total commercial real estate loans at all FDIC-insured institutions in Kentucky rose from $8.7 billion reported year-to-date on June 30, 2008, to $9.3 billion as of June 30 of this year.

"The numbers speak for themselves in the banking business," Deaton said. If you've got your financial statements, if you've got your cash flows like you were supposed to have all along, you should know if you could get a loan or not."

While the downturn in the economy caused Central Bank to re-examine many of its policies in the interest of turning its weaknesses into strengths, Deaton said, the bank did not change its lending philosophy at all. Central Bank has not lost money during the economic downturn, Deaton said. The company has also seen its earnings rise in recent months, and it is continuing to make investments and donations to support the community, according to Deaton.

"I think it's not so much the banks," Deaton said. "I think it's the borrower who wants to make sure it's the right thing for them to do."

Deaton said he has sensed some apprehension on the part of his national counterparts at a recent gathering of the American Bankers Association.

"A lot of them are having a problem with growth," Deaton said. "A lot are having a problem with commercial real estate in their market. It's a concern not only to the bankers; the regulators are focusing on it also."

In testimony on November 2 before a subcommittee of the House Committee on Oversight and Government Reform, Jon Greenlee, associate director of the Division of Banking Supervision and Regulation at the Fed noted that more than 16 percent of all construction and development loans were considered delinquent at the end of the second quarter. Loan performance problems were the most striking for those that financed residential development, according to Greenlee.

Of particular concern, he noted, is that almost $500 billion of CRE loans will mature during each of the next few years. These loans, he warned, will not be rolled over very easily.

Prices of existing commercial properties have already declined substantially from the peak in 2007 and will likely decline further, Greenlee continued. "As job losses have accelerated, demand for commercial property has declined and vacancy rates have increased. The higher vacancy levels and significant decline in the value of existing properties have placed particularly heavy pressure on construction and development projects that do not generate income until after completion."

Developers typically depend on the sales of completed projects to repay their outstanding loans, and with prices depressed amid sluggish sales, many developers are finding their ability to service existing construction loans strained, he noted.

As a result, Federal Reserve examiners are reporting a sharp deterioration in the credit performance of loans in banks' portfolios and loans in commercial mortgage-backed securities (CMBS).

"The current fundamental weakness in CRE markets is exacerbated by the fact that the CMBS market, which previously had financed about 30 percent of originations and completed construction projects, has remained closed since the start of the crisis. Delinquencies of mortgages backing CMBS have increased markedly in recent months. Market participants anticipate these rates will climb higher by the end of this year, driven not only by negative fundamentals but also by borrowers' difficulty in rolling over maturing debt," Greenlee testified. In addition, he said, the decline in CMBS prices has generated significant stresses on the balance sheets of financial institutions that must mark these securities to market, further limiting their appetite for taking on new CRE exposure.

Regulators require banks to maintain strong capital levels to cushion the blow of losses from bad loans and to accurately identify their potential losses when they modify troubled loans. Keeping those capital levels high, however, often means banks can't make that capital available for additional credit for small businesses and other borrowers. Instead, they have to use the capital to account for current and projected future loan losses.

Banking officials are expressing frustration with the way regulators are interpreting the rules addressing how much capital the banks should be required to have on hand for losses or potential losses against those assets. The interpretations are said to be causing banks to use real capital for theoretical real estate losses, and that places additional stress on bank capital levels.

Unlike the residential housing market or the automotive industry, there has been no rescue in sight for commercial real estate. While some believe government intervention is in order, others feel the market is simply due for a correction.

"I'm not much on the Feds getting involved," Haymaker said. "The market needs to set itself. When people overbuild, throwing money at the deal doesn't solve the problem because there is still too much capacity. Unfortunately, I believe some people have to fail."

According to Cole, a little of both may be in order.

"The federal government has got to tackle this problem the same way they tackled the auto industry and residential lending," Cole said. "They've got to come up with some avenues for borrowers to go out and refinance these loans. That's the bottom line."

"It's also a correction," Cole added. "A lot of these properties unfortunately are going to have to go through the process of foreclosure. They're going to settle on their real world value."

Despite the current difficult circumstances for commercial real estate, most local developers said they have also seen some hopeful signs in recent months of renewed activity and they believe there is investment money waiting on the sidelines for the right opportunity.

"2008 was just a horrible, horrible year," Cole said. "The first three quarters of 2009 were the same. … In July (2009), it's like somebody switched on a light switch. All of a sudden, there's activity and leases are being signed. I think we have started the recovery. I think it is way too soon to even suggest how long it will take."

"The good news is, if there is a floor, I'd like to suggest that we've hit it," Cole said.

"I know lots of people who tell me they've got their money back in the stock market and they're just waiting," Haymaker said. "Everybody expects a deal. The tenants expect a deal, the customer expects a deal from the tenants and the landlords expect help from somebody."

But as the market continues to correct itself and more big-box retail stores are left empty, Haymaker said the real challenge will be finding a good use for those properties.

"What you don't want to do is turn them into roller rinks, and everything seeks its lowest level," Haymaker said. "But there is just too much capacity and too many stores for the consumer dollar. … I don't know what to do about all of that empty real estate."