What started out as a credit crisis in residential real estate has now spread to commercial real estate. Most troubling is that the fundamentals of CRE are crumbling: occupancy of properties is declining as many tenants struggle in the ongoing recession.
Banks and thrifts will suffer in a commercial real estate downturn because they own nearly 50 percent of all commercial mortgages outstanding. Many of these institutions are particularly vulnerable. As of Sept. 30, 2008, some 1,400 commercial banks and savings institutions had more than 300 percent of their Tier 1 capital in commercial mortgages, according to Foresight Analytics. Regulators consider anything over 300 percent to be excessive.
Bankers should be intelligently aggressive in dealing with the upcoming storm, but many are frighteningly ill-equipped to handle it. They need to follow a few basic rules to ensure that troubled commercial real estate loans do not bring their institution to its knees.
Rule No. 1: Maintain the quality of the property. To the extent possible, a bank should work with the borrower to formulate a maintenance plan. If the borrower is not cooperating, the bank should take swift action to pursue its legal remedies and gain control of the asset.
In many situations, the market value of the problem asset will be less than the loan amount. This is not the time to ignore the asset. It is difficult, if not impossible, for the property to recover from the stigma of appearing troubled. Leasing brokers will hesitate to show the property to prospects, tenants will balk at renewing leases, and the value of the property will plunge. A detailed asset management plan will consider advancing monies for capital expenditures, leasing commissions and tenant finish allowances.
Rule No. 2: Properly staff an in-house real estate department to deal with troubled loans. The solvency of many banks will be determined solely on the success or failure of this department. Banks often fall into the trap of moving loan production staff over to the loan workout department. This is a mistake. It takes a unique set of skills to negotiate troubled loans and to manage real estate. One bit of good news for banks is that they can take advantage of the many qualified real estate professionals who are currently seeking employment.
Rule No. 3: Retain the services of a group of third-party real estate advisers and brokers. This is not the time to seek out the low-cost service provider. If the borrower seeks forbearance on payment terms, it may be a good time to require that the borrower retain a third-party workout firm to assist in formulating alternative workout plans.
Additionally, the workout firm can provide assurances to the bank that the asset quality is being maintained and keep the bank updated on the borrower's or guarantor's financial situation. Hire the best leasing and sales brokers available, and remember that brokerage firms are generally asset-class specific, such as retail, office, industrial, and so on.
Rule No. 4: Thoroughly understand the credit climate, and be creative in dealing with problem loans and real estate owned by the bank. A bank holding a troubled loan often believes the best solution is to move the loan to another bank. Or, the bank requires the borrower to make principal reductions on the loans before it will consider a restructure of the loan. This is the proverbial "pushing on a rope." Unless the bank is willing to take a substantial discounted payoff of the loan, the loan will stay on the bank's books indefinitely. If the bank determines that the borrower should no longer hold title to the asset, it should consider a legal transfer, in-lieu of foreclosure.
As a general rule, once a bank owns a property, the value of the property decreases 15 percent to 25 percent. A bank should have a well-developed plan before taking title to the property. It should consider alternatives such as providing creative financing for new buyers, then selling the seasoned loan at a later date to other banks or private parties.
Rule No. 5: Consider bulk-sales of troubled real estate loans or properties via auctions only as a last resort. Bulk sales result from laziness on the part of bankers. When a bank embarks on a strategy of bulk-selling troubled loans or real estate owned, it is as if it has embarked on a strategy to maximize the losses for their real estate portfolio. Negotiated transactions, while taking longer, always result in a much higher sales price. The goal should be to minimize losses, not maximize them.