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CRE Finance World, Winter 2013

Construction Debt Casts Long Shadow Over Banks’ CRE Portfolios “Looking at the big picture, FDIC data for the nation’s 7,246 banks and federally chartered thrifts showed commercial real estate (CRE) asset quality indicators continued to improve in the first half of 2012.” Chart 3 Loan classification distinctions are important for accurate structuring, Median Construction and Development Loan Concentrations by Lender Asset as well as reporting. A loan backed by an income-producing property Size: 2003–2012 relies on the performance of that property for the repayment of the loan. The loan is underwritten based on the ability of future property revenues (in the form of rent and lease payments) to cover both future property expenses and the debt service of the loan. On the other hand, a loan backed by an owner-occupied property is essentially a business loan with additional collateral (the property) pledged as credit support. In this case, the loan is underwritten based on the ability of future business revenues to cover both business expenses and the debt service on the loan. Five years after the crash, many banks still haven’t come to grips with how to deal with distressed construction projects. The reasons banks are having difficulty revolve around three issues: first, there may be no expertise to complete the project, especially if the owner has walked away; second, there’s no capital available because the money has run out; third, in many cases, market conditions do not support the real estate as underwritten. All three conditions create a perfect storm for banks stuck with these loans. Slow-Growth Economic Recovery Extends Banks’ Pain Although fundamental economic health is necessary for real CRE sector recovery, most economic growth measures are only weakly positive. Still, as 2012 closes, traditional drivers of CRE rent growth and demand have begun to track stronger than the broad market (and magnitude of CRE distressed debt) would suggest. Also, corporate balance sheets are showing increased strength. Sobering, But Enlightening, Statistics It’s apparent that banks that hunker down to conduct detailed Another bright spot, home prices continued to rise in the third analyses of their CRE loan transactions may find some surprises. quarter of 2012. The National Index was up 2.2% over the second quarter of 2012 and 3.6% above the third quarter of 2011, as For instance, if a significant portion of commercial real estate reported by S&P Case Shiller Index. Improvement in the residential loans are secured by owner-occupied properties, these loans are market may also boost commercial property, as a strong housing essentially commercial or business loans and ADC exposure is market helps increase consumer spending. likely understated, particularly for smaller banks. Once residential prices improve, pricing clarity will provide much Portfolio analyses for banking and CRE investor clients have more certainty for investors looking to purchase distressed loans, turned up “misclassified” loans for residential lots, spec homes, or banks attempting to work them out. built-to-suit industrial space for builders and building companies. Ultimately, community and mid-sized banks likely will face more Many times, loans are written where primary or secondary residences difficulty than their large counterparts, as the entire banking of business owner-borrowers serve as additional collateral to CRE system deals with unprecedented pressure. loans. Additionally, there are single-tenant office/industrial with little marketable value. A publication of Winter issue 2013 sponsored by CRE Finance World Winter 2013 53


CRE Finance World, Winter 2013
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