Real Estate Problems Proving Intractable

Even as the economy shows signs of rebounding, bankers are still mired in worsening real estate problems that a recovery in other sectors will not solve anytime soon.

"What we have now is a unique set of circumstances. Even a recovery in the economy won't create demand for new offices, hotels, or commercial space," said Kenneth Leventhal, whose firm, Kenneth Leventhal & Co., specializes in real estate workouts.

Rents Seen Declining

Anthony Downs, who follows real estate at the Brookings Institution, said: "Things are pretty lousy. Rents are still falling, and will for the rest of this year and a good part of next year."

New real estate problems keep cropping up. In the first quarter, 33 banks added $7.8 billion in problem loans, according to Oppenheimer & Co. That pace almost matched the catastrophic fourth quarter of 1990.

In other words, banks' real estate crisis is likely to get worse before it gets better, and bankers would be well advised to start digging in for the long haul.

"In my view, we could be in a long, shallow recession, one that in varying degrees lasts for several years, rather than a more traditional bounce and back up," said Robert Dugger, chief economist for the American Bankers Association - an expert whose downbeat view carries considerable weight with his group's constituents.

Instead of benefiting from a general recovery, real estate problems could slow one. If banks sit with sour loans, the loans could go from bad to worse. But quick foreclosures could further weaken the condition of real estate markets, a major component of the overall economy.

Desperately Seeking Solutions

Trapped in this paradox - damned if they pull the rug and damned if they don't - bankers are scraping for new solutions, even at the expense of exacerbating the large problem.

The latest trend, for example, is writing loans with provisions for faster amortization of principal. This is supposed to shield banks from asset devaluation. Experts predict that such seemingly draconian credit requirements will ripple far beyond the real estate sector.

Statistics suggesting that banks' real estate portfolios are in better shape now are not as hopeful as they might seem.

The $7.8 billion of new problems reported by the 33 banks covered by Oppenheimer is off from $9.2 billion in the fourth quarter. But analyst Christoph Kotowski warned against reading too much into the reduction, saying banks usually postpone reporting the problems until the second half of the year.

The BNE Effect

Moreover, he said, a sharp decline in new problems in the Northeast was partially due to removing the Bank of New England from the list of banks after it was seized by the Federal Deposit Insurance Corp.

Oppenheimer, a New York based investment house, measures new problems by adding the change in nonperforming assets to loan losses and the expense of owning foreclosed property. The statistic includes a small component of debt for highly leveraged transactions, but Mr. Kotowski said the HLT debt will dissipate more quickly than real estate.

To be sure, rental apartment units should start to appreciate in value once young people riding out the recession at their parents' homes head out on their own. And industrial space could rebound as other sectors of the economy pick up late this year.

But offices, hotels, and retail space are in "secular" oversupply, said David Shulman a managing director at Salomon Brothers Inc. If his assessment is correct, markets will not regain much vigor for two years or more.

"It varies from bank to bank, but there is a lot of pain to be felt," Mr. Shulman said.

Slowdown in California

The commercial realty market in Southern California is "decelerating very rapidly," conditions in New England remain "very poor," and new problems are cropping up in such midwestern cities as Chicago, Indianapolis, and Minneapolis, he said.

But there are rays of hope in these generally gloomy assesments.

Jeffrey F. Fastov, associate director of Moody's Investors Service Inc., predicted in a study of 102 markets released last month that over half will recover at least some vigor over the next five years, with only a handful of midwestern markets expected to weaken over time.

Could Get Worse

Near-term prospects look daunting, however.

A bad situation could get worse if the current trend toward foreclosures continues, Mr. Fastov said.

The first-quarter bank reports seemed to confirm recent talk that banks are seizing property from developers rather than working out loans, as most increased their real-estate-owned portfolios faster than nonperforming loans.

Tenants Will Have More Say

That means rental income could fall still further because the seizures will remove a "natural floor" in rental rates that is created by the developers' need to service debt, Mr. Fastov said.

Banks, he said, have little incentive to exact rents above what tenants are willing to pay.

Falling rents will drive down the value of these properties, because the price investors are willing to pay is based on the cash flow a commercial property creates. Competition for tenants in an oversupplied market will drive rentals at other properties down as well, pushing more properties into the bad-loan category.

Banks already may be pricing property 15% too high based on the cash flow those properties are producing today, Mr. Shulman said.

Falling Values

As fast as bankers slash prices trying to sell, Mr. Fastov's warning suggests, values could fall faster.

"The bankers and developers are kind of like crewmen on the Poseidon," said Mr. Leventhal, whose accounting firm that specializes in workouts.

Contrary to what is fast becoming conventional wisdom, he argued that banks won't go overboard with foreclosures.

Chicken-or-Egg Quandary

Another problem in disposing of the real estate is the inability of potential acquirers to get financing from banks or anyone else, Mr. Leventhal said. "There is just no liquidity in the market."

Ever since the onset of widespread real estate problems in late 1989, a chicken-or-egg quandary over banks' role in the crisis has raged among the experts.

People in the real estate business generally blame banks and their regulators for causing the crisis by discouraging new loans. Others say the withdrawal of banks from the marketplace is the appropriate reaction to a lack of creditworthy projects.

That debate still was raging last week. But the analysts were focused not on who is to blame for current conditions, but on the implications of credit policy for the future.

Mr. Leventhal, in fact, suggested that a speedy turnaround will depend on a change in attitude by examiners.

Watching the Regulators

He said upcoming quarterly results of California banks will provide an early indication. If the regulators respond to jawboning from the Bush administration and ease up, he said, fewer new problems will be reported. And that will be a sign that banks are being encouraged to lend again.

He said, however, he doubted the talk in Washington would have any effect. "We haven't seen it in the field," he said.

Mr. Shulman would not deny that tighter credit is a major characteristic of the crisis - and its aftermath.

"Equity, recourse, and amortization will be the words of the day," he said, referring to tighter loan terms that banks will impose to shield themselves from credit risk.

Applauding the Concept

Smart bankers already insist on higher levels of equity and recourse, said Carl W. Yoder, executive vice president of Valley National Bank in Arizona.

But he said the pace of amortization suggested by Mr. Shulman would be "impossible" to achieve. "I applaud the concept, but can you get it done? Will the property support it?" he said.

Such standards are already in effect, said Mr. Dugger of the ABA, adding that they are likely to ripple far beyond the real estate markets.

"Real estate is not unique," he said. "The terms of credit for all bank borrowers are going to be tighter."

PHOTO : Sour Loan Patterns Vary by Region

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