Loan Loss Reserves Restrict Banks From Making Commercial Real Estate Loans

In addition to keeping an eye on declining property values, falling rents and rising vacancy rate numbers, the commercial real estate community is also concerned over ominous signs in banking industry numbers.

One big area of concern is the fact that banks are stowing away more money to cover problem loans. The amount being set aside is rising rapidly and is now higher than it has been for a quarter of century. Meanwhile, the amount of problem loans is rising at even more than twice that rate.

The implications of the increased loan loss coverage for the commercial real estate industry is that it will likely further limit the amount of money available for borrowings. Those numbers also signify that this will continue to encourage “extend and pretend” policy that some lenders have pursued, and it may further encourage lenders to be optimistic about their recovery rates to avoid taking further losses/writedowns. And at the same time, lenders won’t hesitate in demanding more money out of borrowers’ pockets.

Mark Fitzgerald, senior debt analyst at Property and Portfolio Research (PPR), a CoStar Group subsidiary, keeps track of the rising levels of loan loss reserves and problem assets and the ratio between the two. Similar to what happened in the early 1990s, bad loans are piling up so fast, banks can’t increase reserves fast enough without showing huge negative earnings, he said.

“It looks like the loan loss allowance to noncurrent loan ratio began declining in second half of 2006,” Fitzgerald noted. “Noncurrent loans and leases began increasing in second half of 2006, whereas loan loss allowances began increasing in second half of 2007. The average from 1992-2009 is 1.33, compared to 0.58 today.”

Put in dollars, that means that for the past 15 years or more, banks kept aside an average $1.33 for every dollar in bad debt they were carrying on their books. Today, banks have only 58 cents set aside.

“The biggest takeaway from those numbers is that banks will continue to need to carefully manage their way out of this — timing of earnings, reserves, and write-offs are all critical to keeping capital ratios intact,” Fitzgerald said. “As delinquencies continue to rise, reserves will need to be kept at high levels, and new lending could be restricted for some time.”

Patrick Fitzgerald (no relation to Mark), CCIM, vice president, REO Property at KeyBank Asset Recovery Group, has been on one of the major front-lines fighting the effects of the recession: Florida.

“There is pro-cyclicality in the reserves such that in good economic times the reserves get built up a bit as they are sparsely used and in bad they are tapped to cover losses. It’s not surprising to see the coverage ratio decline,” Patrick Fitzgerald said.

“During 2009, most line employees in banks spent the majority of time going through loan portfolios and figuring out exactly what they had, how much underlying collateral values had changed, and aggressively marking-down distressed and non-performing loans to reflect new recovery assumptions,” Patrick Fitzgerald said. “Thus, a lot of reserves were used in 2009 as loans were charged-off (partially or in full) to essentially mark-to-market the loan book.”

In addition, KeyBank’s Fitzgerald noted that federal banking regulators — in Washington, at least – have shown banks a willingness to allocate less reserves as a percentage of non-performing loans.

This should be a bullish signal to the market, Patrick Fitzgerald said. “At a minimum it says that the belief is that things are getting less bad. We’ve gotten our arms around our loan book and although non-performing loans may still grow a bit, we believe the biggest write-downs are in the rearview mirror. And if this isn’t the case, God help us all.”

Indeed, year-end balance sheet numbers for banks do show some hope. The amount of some noncurrent loans decreased in the past quarter for the first time in years. For example, the total amount of noncurrent construction and development loans fell for the first time in four years. In addition, the average net charge-off ratio also improved after peaking in third quarter, and early stage delinquency trends showed promise.

Despite these signs of stability, the bad news is that the increase in overall noncurrent loans last quarter was driven largely by real estate. The amount of real estate loans secured by nonfarm nonresidential real estate properties that were noncurrent rose by $4.5 billion (12.2%). And such exposure will likely necessitate considerable more reserves this year. So while some forms of lending seem to be coming out of the woods, banks will still be trying to clear a path through the commercial real estate thicket.

“Loan delinquencies and defaults continue to rise as expected, but they still fail to capture the enormity of distress in the commercial real estate market, as most properties are still producing enough cash flow to adequately meet debt payments,” writes Josh Scoville, Director, US Equity Research at PPR in PPR’s Daily Update for March 10. “However, given the massive correction in property values, it is increasingly likely that assets with debt are upside down – i.e., the property value has fallen below the principal left on the loan. This may be all fine and dandy in our extend-and-pretend world as long as two things occur: 1) the cash flow remains high enough to continue to meet debt service, and 2) there are no major capital events required to maintain the asset. With market cash flows falling, the first requirement is under growing pressure, and this distress is directly reflected in the rising delinquency and default rates. However, the latter requirement may be an even bigger issue, as debt maturities continue to force capital events.”

“The banks are trying desperately to survive the current crises without facing up to massive losses,” said Robert D. Domini, MBA, MAI, president of Continental Valuations Inc. Perrysburg, OH. “With delinquencies mounting, loan loss reserves are definitely falling behind. How long [banks] can hold off will depend on how bad the commercial real estate crisis gets. Vacant, deteriorating buildings in default can’t be papered over for long.”

Read the whole article at CoStar.

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