WORD ON THE STREET: Weakness in real estate markets, both commercial and residential, continues to be a drag on the overall growth of the economy. Construction of nonresidential structures continues to lag because of weak fundamentals in the sector, including high vacancy rates and low property values – factors that are unlikely to change in the near term. Similarly, new-home construction is likely to be constrained by the continuing overhang of distressed and vacant homes.
Commercial real estate (CRE)-related issues also present ongoing problems for the banking industry, particularly for community and regional banking organizations. Losses associated with CRE, particularly residential construction and land development lending, were the dominant reason for the high number of bank failures since the beginning of 2008, and further CRE-related bank failures are expected over the next few years.
While we expect significant ongoing CRE-related problems, it appears that worst-case scenarios are becoming increasingly unlikely. CRE portfolio loan concentrations are not a significant risk factor for systemically important financial institutions. Some systemically important financial institutions have substantial exposures to commercial mortgage-backed securities (CMBS) and to derivatives securities such as CRE collateralized debt obligations. However, risks in these areas have been reduced, as significant markdowns have already been taken on these securities.
In addition, conditions in the CMBS market have been improving, with spreads tightening and some new deals coming to market. However, we see losses in CRE to be an ongoing negative factor in bank portfolios that will need to be worked through over the next several years.
Current conditions
Underlying market fundamentals of CRE remain a significant concern, but they have shown some signs of stabilizing. For instance, vacancy rates on office, industrial, and retail properties have stopped increasing, although they remained at elevated levels at the end of 2010, ranging from 13% to more than 16%, depending upon the property type and location. These levels are, on average, five to six percentage points above levels experienced in 2007.
The rate of decline in rental rates has also slowed. At the beginning of 2010, office and industrial rental rates were between 10% and 12% lower than a year earlier, on average, but declines had slowed to between 5% and 7% at an annual rate at the end of the year. Sales volume of CRE properties improved each quarter during 2010, accumulating to almost $135 billion for the year as a whole. This total is double the CRE property sales volume for all of 2009.
At the end of the third quarter of 2010, approximately $3.2 trillion of outstanding debt was associated with CRE, including loans for multifamily properties. Of this amount, about one-half, or $1.6 trillion, was held on the balance sheets of commercial banks and thrifts. An additional $700 billion represented collateral for CMBS, and the remaining balance of $900 billion was held by a variety of investors, including pension funds, mutual funds and life insurance companies.
Outstanding CRE debt has contracted 6% from its peak in 2008, while outstanding CRE loans at banks have contracted by almost 12%. Most of the decrease in bank loans was associated with reductions in construction and development loan balances, which were largely the result of foreclosures and charge-offs.
Despite the decline in aggregate CRE loans at commercial banks, many banks still have CRE loan concentrations, as defined in the 2007 ‘Interagency Guidance on Concentrations in Commercial Real Estate.’ Banks are considered to have a CRE concentration when loans for construction, land development, and other land exceed 100% of risk-based capital, or when total CRE is greater than 300% of risk-based capital.
By this definition, almost 1,200 commercial banks, or 18% of all banks, had CRE concentrations at the end of the third quarter of 2010. CRE concentrations have been the dominant factor in bank failures. Of the more than 300 commercial banks and thrifts that have failed since the beginning of 2008, more than three-fourths had CRE concentrations at year-end 2007.
Notably, CRE concentrations are not a significant issue at the largest banks. Among banks with total assets of $10 billion or more, 10% had CRE concentrations. In contrast, one-third of all banks with assets between $1 billion and $10 billion had CRE concentrations. For banks with less than $1 billion in assets, approximately 17% had CRE concentrations.
Credit quality
At the end of the third quarter of 2010, almost 10% of CRE loans in bank portfolios were considered delinquent – a three-fold increase since the end of 2007. Not surprisingly, loan-performance problems have been most striking for construction and development loans, especially for those that finance residential development. Almost 19% of all construction and development loans were considered delinquent at the end of the third quarter of last year.
During 2010, delinquency rates on construction and development loans began to improve slightly, falling 1% in the first three quarters of 2010. Additionally, delinquency rates on loans backed by existing non-farm, nonresidential properties leveled off in 2010. Still, even if CRE delinquency metrics continue to improve, there remains a sufficiently large overhang of distressed CRE at commercial banks such that loss rates for this portfolio will likely stay high for some time and many banks with CRE concentrations will remain under stress.
Approximately one-third of all CRE loans (both bank and nonbank), totaling more than $1 trillion, are scheduled to mature over the next two years. This circumstance represents substantial refinancing risk, as CRE loans typically have large balloon payments due at maturity. Banks have been dealing with maturing loans in a variety of ways, including providing extensions of performing assets, troubled debt restructurings, equity injections, collateral sales and, in some cases, the pursuance of foreclosures.
Since the beginning of 2008 through the third quarter of 2010, commercial banks have incurred almost $80 billion of losses related to CRE exposure, equating to a little over 5% of the average exposure outstanding during this time. In past cycles, CRE credit and market fundamentals generally lagged the larger economy by a year or more.
Given this historical experience and the recent improvement witnessed in the broader economy, it is estimated that banks have taken roughly 40% to 50% of the CRE losses that they will realize over this cycle. Using past cycles as a guide, we expect that the remaining losses will likely be incurred over the next few years.
The Fed steps in
Since the quality of CRE loans at supervised banking organizations began to weaken, the Federal Reserve has devoted significant additional resources to assessing the quality of CRE portfolios. These efforts include monitoring the impact of changing cashflows and collateral values, as well as assessing the extent to which banks have been complying with our CRE guidance. Examiners have taken a balanced approach to ensuring that banks are recognizing losses in a timely manner, maintaining sufficient loan-loss reserves and monitoring collateral values while being mindful not to discourage healthy banks from making loans available to creditworthy borrowers.
Additionally, in an effort to encourage prudent CRE loan workouts, especially among maturing loans, the Federal Reserve led the development of inter-agency guidance issued in October 2009 regarding CRE loan restructurings and workouts. To better understand the effectiveness of this guidance, the agencies conducted a survey of financial institutions during their examinations. The survey was completed in the third quarter of 2010.
The survey was designed to gain an understanding of the current trends in the institution's CRE portfolios and an estimation of the volume of loan restructurings that are likely to occur within the next year. The majority of respondents described the quality of their CRE portfolios as relatively stable but expressed concerns regarding borrowers' deteriorating repayment abilities and declining collateral values, which were of particular concern where maturing loans no longer met the institution's underwriting standards.
Approximately two-thirds of the respondents were engaged in loan workout activity. Of note, respondents reported that almost three-fourths of loan modifications were performing according to their modified terms. The survey also noted that the volume of future CRE workouts is estimated to increase by approximately 60% this year 2011. In contrast, banks have only restructured approximately 5% of all outstanding CRE portfolios to date.
Patrick M. Parkinson is director of the division of banking supervision and regulation for the Federal Reserve System. This article is adapted and edited from testimony presented Feb. 4 before the Congressional Oversight Panel in Washington, D.C. The full text of the testimony is available here.
