I had the pleasure of listening to a conference call with Matt Anderson of real estate market consulting firm Foresight Analytics last week, sponsored by Oppenheimer & Co. The call was billed as a state of the construction financing market review, but it was really a tour de force on the real estate, banking and CMBS markets. As these markets were and are still ground zero in the financial crisis, I thought it would be worthwhile to review exactly where we are in the healing process, particularly in light of the latest funk that has settled over the credit and equity markets.
According to Foresight, commercial construction deliveries are down from just over $200 billion in 2008 to approximately $75 billion in 2010. This level of activity is lower than the prior real estate cycle troughs of 2003 and 2002 and close to 1976 trough levels. Next year is also expected to be weak in terms of construction activity - not unexpected. Residential construction starts peaked in 2005 for both single-family and multi-family units. Single-family unit starts were about 1.7 MM, which eclipsed the 1978 level of about 1.4MM, when population was growing quite a bit faster. The trough was around 475,000 in 2008 (the lowest post World War II) and is currently running around a 600,000 rate, bumping up to about the trough levels seen in the 1982-1983 recession, and still well below recessionary 1992 levels. Multi-family starts of just over 2MM units followed a similar pattern.
In 2007 there were $90 billion of office building starts. This number is running about $37 billion in 2010. Warehouse construction value is down even more, declining from about $120 billion at 2007's peak to about $21 billion in 2010, which is actually an uptick from 2009. Total construction loans peaked at about $610 billion in 2007 and have declined to about $400 billion in 2009. Construction lending will be down in 2010 and likely in 2011. Construction loan delinquencies have been ballooning with condo loan delinquencies running an incredible 40%+ since late 2008 (although they appear to be peaking), and single-family construction loan delinquencies around 27% (they have been moving ever so slightly lower since mid 2009), according to FDIC data. Just under 14% of rental apartment construction loans are delinquent, with commercial construction loans just a shade behind. Neither of these give any appearance of slowing down from their currently less horrific levels.
From the work that I do on banks I can tell you that banks have been forced to "get busy" writing down their bad construction, development and land loans, particularly because of the very high severity of losses associated with this kind of paper. (In some areas where buildings can be purchased for less than their construction costs, the residual value analysis on land kicks out a negative value - as in "you'll have to hold the land for a long time and pay taxes on it before you can sell it or develop it.") As a reward for aggressively writing down bad construction, development and land loans, reserving for the eventual losses on disposal and raising enough capital to cover such losses, the FDIC allows you to stay in business. There is one more minor perk....you instantly get added to the list of surviving banks, which of necessity will be allowed to bid on and acquire other failing banks that did not "make the grade." While competition in these bids has heated up (the discounts to already written down asset value being bid have declined) and the FDIC has feathered back its 90/10 loss sharing deals to an 80/20 split, it is banks that are getting the opportunity to "shoot fish in a barrel" today rather than private real estate investors and REITs, which had the better opportunities in the old RTC days.
Now here is where it gets interesting, in my view, while banks (which equity investors have tapped as survivors) have raised enough money to deal with their land, development and construction loans, they have not necessarily raised enough money to deal with all their bad commercial (investor-owned and owner-occupied) loans. The issue is not so much delinquencies, which while they are a problem, are nowhere close to as big of an issue as dud construction loans. Rather, the more pressing issues are potential maturity defaults. First let's define some terms. A maturity default is when the loan of a borrower, who was making their loan payments, comes due, and that borrower can neither find a new loan to take its place, nor afford to pay off the remaining amount due under the loan. Let's look at a theoretical example of how this could happen.
Let's say that I bought a property for $10 million that generated net operating income (NOI) of $700,000 per year. I took out a five-year mortgage at 6% (typically with a 25-year amortization schedule) at an 80% loan-to-value ratio. This loan would have a debt service coverage ratio of 1.2x (these were pretty standard terms a couple of years ago). In the interim my NOI fell to $650,000 and the loan amount amortized down to $6.9 million; unfortunately, due to worries about the economy and declining rents and NOIs in the market, the appraised value of the property has fallen 20% to $8 million. Now that the loan is maturing the borrower needs to get a new 5-year loan (interestingly; rates are similar), but let's look at the new underwriting. The borrower needs $6.9 million on an $8 million property or an 86% LTV, a non-starter, when most banks have lowered the LTVs they will offer to 65% or less. Interestingly, in this case the debt service coverage ratio would remain 1.2x, so the cash flow from the property, although down somewhat, fully supports the debt needed. In some cases the NOI would be down even more and the debt coverage ratio would be insufficient to meet tighter banking standards of 1.25 or more now required in many cases. It's easy to see that banks are facing situations where perhaps a borrower could stay in a property if underwriting standards were made more lenient, or if they didn't have to meet both the LTV and DCR standards, but these borrowers would be unlikely to be offered another loan if current lending standards were strictly enforced. According to the many banks from across the country that I have talked to in recent months, the regulators are in no hurry to turn these marginal loans into bad loans right away. One really big motivation for the regulators participating in the pretend and extend strategy is that they too are short on capital, with the FDIC in particular out of money and raising its insurance premiums to banks as quickly as it can. True also, they learned from the experience of the early 1990s, when overzealous ex post facto regulation caused banks to write down collateral backing delinquent loans to levels that had to be reversed and written back up a few years later. Many more properties were blown out for big losses that would have recovered significant value later and the government lost money on properties it took over from failed banks by selling them through the RTC hastily.
According to Foresight, there are $270 billion of commercial and multi-family mortgages maturing in 2010 and $300 billion per year maturing between 2011 and 2013. However, about 60% of these loans are currently being extended. This means that the lender is being allowed to stay in the current mortgage, beyond its maturity date, with the current terms and underwriting standards. In some cases banks are entering into troubled debt restructuring agreements or "TDRs," a term you will be hearing more and more about. In these cases, the bank may require the borrower to post additional collateral against the loan. In extreme cases they will segment the loan into a good "A" piece that the borrower's property can support and write-off the bad "B" piece (with numerous variations on this theme). Foresight notes that commercial real estate prices are down much more than our example above, or roughly 42% according to Moody's, so there is apt to be a lot of situations where the messier "A" piece "B" piece scenario wins out over a standard "kick the can style" TDR.
Considering that banks hold a little bit more than 50% of the commercial real estate loans that will be maturing, bank solvency is still very much an issue to be grappled with going forward. Interestingly to me, the CMBS market, which seemed much more loosey goosey than the bank market, is reportedlly seeing similar default rates thus far. Acccording to Ken Rosen, of Rosen Real Estate Securities, Inc., there will be a similar $1 trillion of CMBS loans to be restructructured over the next couple of years, but with an improving economy and virtually no new construction, the severity of losses may not be extreme. Of course, the single-family residential debt issue is a much more severe one for the economy as a whole, with delinquencies continuing to soar to historically high rates according to Federal Reserve data (View image). According to Foresight, an expected $190 billion of total loans carrying > 100% LTVs by 2012, largely driven by single-family homes. This is a problem for Fannie, Fred, FHA and by way of paternity, Uncle Sam. No wonder the markets are a little freaked out about sovereign debt risks.
If you read the newspaper or surf the web, you know that several well known market pundits and professional investors including 
The stock market has been tracing out a potential top for the last 6 Mos. (See my recent piece 
