REQUIRED READING: Forecasters generally agree that this year and next year, the commercial real estate (CRE) market will experience escalated delinquency, nonaccrual and foreclosure rates, which will lead to more bank closures.
Looking back on the residential housing bust and considering the widely accepted commercial projections, we should consider how to prepare for the challenges ahead in the commercial sector. What can be learned from the residential sector's collapse? How will the CRE market's troubles be different?
Loan delinquency and nonaccrual rates are a clear proxy for upcoming foreclosures, and these numbers are reported quarterly to the Federal Deposit Insurance Corp. by all U.S. banks. The latest data currently available are from the third quarter of 2009. From these data, the trends and broad-based impact on the real estate market as a whole are undeniable.
Loan nonaccrual rates for first-family liens as of Sept. 30, 2009, for all banks nationwide increased nearly 15%, or $10 billion, over the second quarter of 2009, while surging $25 billion, or nearly 47%, over the same quarter in 2008.
Meanwhile, over the same time period, CRE loan nonaccrual rates were up nearly $5 billion, or 18%, from the previous quarter and up an eye-popping 155%, or $20 billion, year-over-year. Unemployment-rate increases generally lag the economic slump, as a result of companies' reactions to the downturn in revenues.
As companies focus on cost reduction through head count, leasehold footprint contraction is a natural outcome. As business locations or storefronts close and businesses fail, more open space is available on the market.
One lesson to learn from the residential housing market's collapse is to not underestimate the speed at which large volumes of defaults could happen. At the beginning of the residential fallout, there was a general thought that banks could survive the crisis without government intervention, but that assumption quickly proved to be false.
A high level of professional skepticism regarding distressed loans is important to get out in front of the issue. Denying or hoping that a distressed loan will improve simply leaves one exposed to the loan's future course. Valuable information can be garnered before the relationship with the payer becomes strained.
Being proactive about both data-gathering and documentation-gathering on a troubled asset prior to its being graded a nonaccrual status will both expedite the decision-making process for the lender and directly affect the rate of return on a distressed-asset sale.
Lenders need to be ready to gather information they do not currently have. Outside specialists can be used to quickly gather information for lenders, saving as much as 20% across the portfolio.
The data and documents first help the bank better understand the underlying distressed asset, as the asset's properties have likely changed since loan origination. At a minimum, the market surrounding the asset will have changed.
Decision-making
Being over-prepared for a loan to go south is impossible, and the more the bank does to understand the underlying distressed asset quickly, the better the outcome will be.
Take quick action based on high levels of data, information and documents. Making decisions quickly without the whole picture can lead to unexpected problems, losses and excruciating internal and external costs.
Employees might spend as much as half of their time just trying to assess a distressed loan. This time expenditure hits the lender in two ways: employee costs and holding costs for the loan or underlying asset itself.
Technology solutions that eliminate the administrative burden and shorten cycle times will save the bank costs in both of these areas, but more importantly, they will free up valuable time to manage loan issues rather than battling just to understand. Managing the issue with clear visibility allows the bank to focus on maximizing returns.
Although we can glean many procedural improvements from the residential fallout, many commercial and/or construction-loan-related issues will simply be different from residential issues. Recognizing these key differences may mean the difference between navigating the storm or succumbing to its fury.
First, commercial assets often have a significantly larger average loan balance, and many community banks or midsize lenders may be more deeply exposed to the commercial downturn than they were the housing crisis.
Simply put, one or two bad commercial or construction loans will mean a much larger financial hit to the bank than a block of bad home loans. Midsize lenders will have fewer resources than large banks to contend with these issues, and may be able to benefit from implementing technology products.
Entering the chain of ownership for a commercial or construction property may expose the bank to unexpected costs, compliance fines and other upkeep costs that significantly exceed those for a pool of residential homes. Duties might include maintaining homeowners' association requirements, detention pond requirements, environmental regulations, common-area maintenance and tenant retention.
The regulations or requirements are unique to every area, state and or project, and may even expose the lender to compliance fines, which can quickly add up and dramatically increase holding costs.
Asset sales
The largest pools of possible buyers of foreclosed homes are the general public or, in some cases, bulk institutional buyers. The buyers of commercial loans or assets are drastically different and much more finite. Investors in commercial loans include companies, real estate investment trusts and hedge funds. Because these firms operate, manage and buy such properties for a living, they typically operate with a high level of sophistication.
Lenders do not operate, manage or sell such properties for a living, which puts them at an immediate disadvantage. Buyers generally understand the details of the asset far better than the bank, and the level of due diligence and documents they require may not be in the loan file or be familiar to lenders.
Documentation needed to make decisions and maximize the return on the sale of commercial assets far exceeds the documentation needed for a residential home. Having a clear process of data and document preparation as a loan enters the delinquent stage is critical to the lender's understanding of the underlying asset and anticipating possible challenges during the sales process. Buyers of these assets will use the lack of information on the bank side to lower bids and negotiate at closing for a more favorable purchase price.
Lenders need to deploy technology that can house both the critical distressed-asset data and the documents in electronic form all in one space. Dealing with boxes and boxes of paper and loads of scanned information or manually checking files is impossible to manage and extremely expensive, and it greatly limits visibility.
The sharing of this critical information throughout the bank is crucial to making the right decisions. Likewise, great benefits are garnered when the technology can monitor files automatically, establish security rights and provide audit trails detailing who is accessing the data.
Once decisions are made internally by the bank, such technology needs to be outward-facing so that buyers and investor objections are eliminated by presenting them with all the information they need and expect up front. This setup serves several purposes: helping the lender to be more knowledgeable or sell directly to buyers, keeping brokers or auctioneers, if any, honest; and ultimately, limiting risks that investors use to lower their bids.
Investors will pay premiums for clean properties. Clean properties start with data and documentation, as internal bank systems and related systems cannot be opened up for viewing by potential investors.
Regulatory restrictions and privacy concerns abound, so new, complementary technology is required to allow the bank to privately, securely and discreetly assess assets, while stacking the deck to maximize returns.
Investors in commercial property will also have clear and defined models for buying assets. As a result, technology can be used to quickly get the right property and the right information in front of as many buyers' eyes as possible. Doing so will help increase bid flow and bid amounts, affecting the level of losses and returns the lender experiences.
Lenders not prepared for this process will find themselves inundated with properties that they are struggling to understand and accurately value. Reactively throwing bodies and consultants at the issue will increase costs dramatically, as well as prolong decision-making and hold times.
Jeff Reibel is founder and CEO of Conexxus Inc., a Louisville, Ky.-based software company and developer of REO Optimizer, which is designed to provide property data to facilitate disposal of distressed development properties. Reibel can be contacted at (866) 608-4321 or jeff.reibel@conexxus.com.
