Banks Worry About Commercial Property Dominoes Tumbling

Ever since the credit markets crashed in late 2007, distressed residential and commercial property loans that were packaged and sold to investors as securities have hogged headlines. Uncertainty over the true value of the securities has shut down the mortgage-backed securities markets, which had grown critical to real estate financing.

But some $1.7 trillion in commercial real estate loans held by banks for retail centers, offices and other properties are just about to emerge as a bigger and uglier problem.

In a research report examining commercial real estate debt just before bank stress-test results came out in May, Deutsche Bank analysts said that tougher underwriting standards and an eventual 50% drop in property values would prevent a "vast swath" of commercial real estate borrowers from refinancing their loans as they come due over the next four years.

Owners Cash-Crunched

In many cases, the properties are now worth less than their outstanding loan balances. In others, lenders will require owners to pump in more equity to obtain refinancing, and most landlords don't possess the cash, experts say.

"We're in a very dangerous time, and I think it's going to get more dangerous as we go along," said Daniel Alpert, a founding managing director of New York-based investment bank Westwood Capital.

The proportion of bank-held commercial real estate mortgages that are 90 or more days past due rose to 2.25% in the first quarter, an increase of nearly 45 basis points over the previous quarter, according to Real Estate Econometrics, a New York-based commercial property analysis firm.

The organization predicts that the percentage will more than double by 2011, before declining.

"The real challenge for the banking industry is to find a way to separate commercial real estate loans that are hopeless from those where something can be done -- and to do it quickly," said Michael Mounts, a managing director in value recovery services at global real estate firm Jones Lang LaSalle, in Chicago. "The properties are all overleveraged, and I don't think that's going to go away any time soon."

Boom Ricochets

That's particularly true for buyers of real estate from 2005 through 2007. Loose underwriting and inflated property values allowed investors to finance purchases with huge amounts of debt, and now the borrowers find themselves underwater.

Yet banks don't seem in any hurry to address such problems: The lion's share of depository institutions are doing everything they can to avoid taking back properties or selling troubled loans at a discount. Those measures would force banks to recognize big losses.

Instead, banks are extending the maturities of problem loans coming due -- those where the value of the underlying property has dropped below the loan's balance, for example, or where borrowers have failed to maintain covenants relating to the real estate, such as minimum occupancy or income, Alpert says.

In some cases, banks are simply not communicating with troubled borrowers, said Tom Brenneke, president of Guardian Management, a Portland, Ore.-based real estate investment firm that owns Sperry Van Ness brokerages in Southern California and Arizona. In particular, executives at small banks are frequently too busy with other issues or don't want to offend longtime customers.

By extending maturities or ignoring problem loans, banks are buying time. They're betting that an improving economy will boost asset values. But many industry observers contend that's unlikely to happen -- they maintain that banks will suffer even bigger losses later as property values continue to drop.

"Smart banks are getting to the mode of selling or auctioning these assets and are stopping that downward spiral in value earlier," said Brenneke, who is overseeing a July 30 auction of bank-owned real estate and other distressed properties through Sperry Van Ness. "The dumb banks are extending loans or aren't talking to their borrowers, and the assets will lose more value."

Lenders Look Warily Ahead

The Federal Reserve Board is due to soon survey banks again about their lending experiences and expectations. Its last quarterly review, in April, reported that more than 90% of domestic banks expected commercial real estate loan quality to deteriorate the rest of the year; about a quarter of senior loan officers said "substantially."

Observers anticipate that the Federal Deposit Insurance Corp. will accelerate bank seizures in the coming months. They say after that, distressed properties that go to market from those closures will only exacerbate the decline in property values.

Forty-five banks have failed this year through June, compared with 25 in all of 2008.

New Tactics Emerge

To convince banks to sell loans now rather than later, some organizations are crafting strategies to soften the blow to bank balance sheets and at the same time earn themselves a profit.

Jones Lang LaSalle is considering developing a "value recognition default swap" in which banks would essentially swap out real estate loans for cash or equivalents. The swap value would be adjusted quarterly based on market variables.

And Guardian Management is working on a structure in which it would partner with banks to acquire an 80% to 90% ownership stake in loan packages, Brenneke said.

"When a bank tells a borrower that it's going to sell his loan," he said, "it motivates that borrower to get to the table quickly and cut a deal."