Red Flags in Commercial Real Estate Could Spell Trouble for Banks

“Real estate has had a great run, prices have gone up, but it’s peaking out and we are at a point where lots of bad things could happen.” — K.C. Conway, chief economist for the Certified Commercial Investment Member Institute

K.C. Conway of the Alabama Center for Real Estate

Last year the commercial real estate industry saw its ninth consecutive year of growth, and most forecasts for this year predict another year of “modest” or “slower” growth. But there are challenges ahead and some economists are leery about 2020 and 2021.

K.C. Conway is chief economist for the Certified Commercial Investment Member Institute and director of research at the Alabama Center for Real Estate at the University of Alabama. Conway says he doesn’t like the way the commercial real estate sector is headed next year and the year after.

Conway points out that following the housing debacle of 2007 to 2009, banks turned pretty much toward commercial real estate.

Then came the Dodd Frank Act, which was supposed to promote financial stability by improving accountability and transparency in the financial system — that is, banks — and protect American taxpayers by ending government bailouts and protect consumers from abusive financial services practices.

“We all thought that Dodd Frank was going to fix all the real estate concentration and issue problems in the banks, and it didn’t,” Conway says, adding that there is more real estate concentration in the banks than any other lending source and a number of things have led to that.

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One thing, according to Conway, is that capital markets — the Commercial Mortgage Backed Securities (CMBS), once a staple in the commercial real estate debt market — are still less than half the size they were before the financial crisis.

“They are struggling to do a hundred billion dollars’ worth of new issuance,” Conway says, “and they have become more selective. They don’t like retail, and there was a lot that didn’t fit the box, and so they have been much more selective and it has been hard to get things through.”

Another issue, Conway says, is that life insurance companies, which have invested heavily in commercial real estate in the past, have gotten more selective and conservative in their underwriting, because capitalization rates (the ratio of net operating income to property asset value) and commercial property values have risen so much the past 10 years.

“They have pulled back and don’t want to do a lot of retail and a lot of new hotel construction loans. They would love to do a big, long-term leased office building, but those are not out there very much, so they are doing primarily a lot of industrial and very select multi-families. The life insurance companies, even though they are flush with money, have been more selective.

“Then there are the GSEs, the Government Sponsored Enterprises, that are pretty much the only game in town,” Conway says. The Government Sponsored Enterprises are Freddie Mac (Federal Home Loan Mortgage Corp. Fannie Mae (Federal National Mortgage Association) and HUD, (U.S. Department of Housing and Urban Development).

“They just keep asking the government for more money. The government controls them, and they went into conservatorship during the financial crisis,” says Conway. “They are very profitable, and the government doesn’t want to get rid of them. So, every year they hit their maximum ceiling, their maximum debt lending, usually by about May or June of each year, and so, they have to go back to themselves and ask for more money to keep lending and make more money.”

Conway says the government agencies have ventured into more areas, away from affordable housing and more toward senior housing and assisted living. “They have gone crazy,” Conway says.

“What concerns me about the banks, the big issue here, is the banks got rid of all their residential subdivision problems and started doing construction lending again, a lot in apartments, because they can easily lay the permanent loan off to Freddy, Fannie or HUD, and they had no re-finance risk. They could get rid of that construction loan easy, and they needed growth,” Conway says.

Conway says he is concerned that construction costs will increase “over 10 percent a year, maybe over 15 percent, this year, and the big reason is we had five category three or four hurricanes over the last two years that are causing labor and materials to be sucked up for all the rebuilding. So, if we have another active hurricane season and another one or two storms hit, you are just going to increase the pressures.”

Construction financing, particularly in commercial real estate, is complicated. According to Alan Tidwell, Alabama Association of Realtors Chair of Real Estate and associate professor of finance at the University of Alabama, says construction financing is a completely different loan than permanent financing.

“It is an interest-only loan that is short term, and you take draws on it,” Tidwell says. “You don’t get the money all at once. You are coming in to build and lay the foundation, and then the bank examiner comes out and makes sure the collateral is in place, the foundation has been laid, then they release the check to pay the general contractor who laid the foundation, and then you do the drywalls or the framing, and then they come back and release the check for that part.”

After the construction period, a takeout lender pays off the construction loan, and the construction lender is paid off once the project is permanently financed, Tidwell explains.

“If it costs more to build than the market is willing to pay, then you got a problem,” Tidwell says, because permanent financing is based on loan-to-value, not loan-to-cost.  “It doesn’t matter if it costs you a million dollars to build it, when you go to get your permanent financing, that financing part is going to be based on the market value as determined specifically by an appraiser.”

Conway says construction loans are underwritten assuming a certain loan-to-cost ratio, which compares the amount of the loan used to finance a project to the cost to build the project. “If you did a 75 to 80 percent loan-to-cost loan and two years later you are at 100 percent and the value didn’t go up that much, you got a real problem. Who is going to take you out in a permanent loan unless that borrower or developer comes up with more equity to blend the deal? We are about to discover that reality,” he says.

According to Conway, next year and 2021 will see record volumes of construction loans come due that have to go to the permanent market and get permanent financing. “No one has been really paying attention to these rising costs, and that the loan-to-cost now is maybe 90 to 100 percent of loan to value,” he says.

Conway says another problem is determining what a project is really worth. “The bank regulators will tell you that we try to look at future value, but you really don’t know what the asset is going to worth until it is built,” he says. “You don’t know what the market is going to be two years from now.

“We are guessing at the market. What is it going to be with the rents? What will the interest rates be? Where is it going to be at cap rate, when we convert the non-operating income into a value?

“The banks argue that not much is going to happen in two years, right? Costs are not going to change. Well, yeah, they are. You get five hurricanes that suck up all the construction labor, all the lumber, all the materials, and now you have a real inflation problem in construction.”

In addition to increasing construction costs, there are the thorny tariff issues. “The steel that we need for structural support, the lumber that comes in from Canada, all the bathroom stuff that go into a hotel room — that is manufactured over in Asia and shipped in here, so it is all subject to these tariffs,” Conway says.

Conway says some banks are remiss in monitoring construction loans. “The regulators are not paying any attention to these construction loans at all. I brief them three or four times a year, and until the last six months they hadn’t even had construction loan risk as an item to look at, even in their bank stress tests. So that is the risk here — you have an underwriting based primarily on the cost.”

Conway says banks and bank regulators are supposed to be doing stress tests to determine what can go wrong on a project and how much capital should be put away to cover the risks that are developing.

“So, in construction,” Conway says, “the banks supposedly should be putting more reserves away for construction loans, anticipating these developers might have a problem. But guess what the bank regulators are letting the banks do? They have been letting them reduce this.

“They have given them all a pass this year, so for the 2018 stress test for 2019 period for the top banks, they gave every single one of them a pass on their stress test, and they gave all of them permission to pay higher dividends to draw down their loan loss reserves for bad loans and for construction money and allowed them to reduce all those allowances to pay out dividends.

“They are trying to keep the banks healthy and attract new capital. So, the regulators are very complicit in this. They have been ignoring this, and telling the banks don’t worry about it, no problem here, you all get a pass, and you can reduce your loan loss reserves so you can pay dividends instead of build them up for this coming problem.”

Then, Conway says, there is the timing issue. “Every decade, we have gone through one of these periods — the ’70s, with the oil embargo and inflation, the ’80s it was the S&L crisis, when all that money and capital sources went away. We have this happen every 10 years. We are 10 years into this recovery, we are 10 years into all commercial real estate prices re-inflating, going back to peaks.

“We are seeing real estate flatten, values are not going up. We hear that multi-family apartment rents are only going up 2 to 3 percent a year instead of 8 to 12 percent. If your rents are going up 2 to 3 percent and your cost to build is going up 10 to 15 percent, you got a problem two years out.

“Real estate has had a great run, prices have gone up, but it’s peaking out and we are at a point where lots of bad things could happen.”

Conway says appraisers have become too dependent on formulaic tests and are not taking in to account the new risks.

“The new risk that is going to get us this time will have nothing to do with the last time. We don’t have the subprime mortgages; we don’t have over-building of housing. So, what is going to blow it up this time is the fact that you are lending more of the cost compared to what the value is going to be when that loan is due.

“You also have this new thing called lease accounting, which, at the end of this year, the U.S. has to go on the same accounting system as Europe and rest of the world, where every company has to put its leases as a liability on its balance sheet. So you could see major corporate credit downgrades of companies, and a lot of these companies are saying, if I have a long 10-, 15- to 20-year lease and I have to put the present value lease of the building as a liability that just kills my capital. They are all saying to the developer, I am only going to give you a five-year lease and I will give you renewal options.

“Well, to the permanent market, the life companies say no, we are structured for 10- and 20-year leases. We fold in life policies and annuities for a securitized bond. Because of tax rules, we can’t have any disruption in that period, so you just don’t fit our modeling. We will go somewhere else where we can get an uninterrupted 10-year lease.

“If that happens, that is the disruption we get next year. Where do the banks unload these construction loans? You will see these concentration risk numbers way higher than they are right now. I think you could see them go to 60 percent or more, and then the regulators are going to make them shut down real estate lending. So, we create another self-fulfilling real estate crisis. I think we are two years away from that happening.”

Tidwell says he is not so sure construction costs will surpass market value but says, “There is a little bit of risk built into the system with price inflation in construction materials, and some of that depends on what is going on in China and what is going on across the world in driving up commodity prices that go into construction. But construction prices have gone up, and if builders continue to build and market prices keep pace, then you could wind up with a few of these loans that could be hard to refinance on a permanent take-out loan.”

Bill Gerdes is a Hoover-based freelance contributor to Business Alabama.

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