Slump in Realty Seen Persisting

The long real estate nightmare is not over yet.

Loan quality will deteriorate through the end of the year, and demand for new construction loans will be depressed for much of the decade, according to a report from Salomon Brothers Inc.

"While individual banks could begin to stabilize in the asset quality department, industrywide we may not have seen the worst of the real estate downturn," the Salomon analysts concluded.

Jobless Problem

The report dashes hopes for a quick rebound in real estate.

Contrary to a widely held notion that realty demand is beginning to revive, shrinking job markets nationwide will slow the leasing of real estate that provides collateral for billions of dollars of bank loans, the analysts conclude.

Before real estate markets recover, investors' outlook will have to improve enough to stimulate demand. But the prevailing mood is not likely to change without more jobs coming first.

The Bush administration has proposed a more lenient bank regulatory atmosphere that might affect the timing of loss recognition, but the ultimate amounts will not change, Salomon analysts noted.

Although data show banks have made progress in recognizing problems and cut off their construction lending before midyear, the report throws cold water on hopes that the climate for real estate lenders will improve anytime soon.

Salomon said the nation's oversupply of office space totals more than 500 million square feet, with construction in progress still exceeding annual absorption of space by 59.8 million square feet to 37.2 million square feet.

That surplus suggests vacancies could still rise from the 19.5% level reached at midyear.

Prospects for a quick recovery in retail space is only slightly better, thanks to negative trends in income and employment growth since mid-1990, the report found.

"We estimate that this real estate bubble will not dissipate for at least five years, and some of the painful vestiges may be with us at the turn of the century."

In the short term, real estate problems will help prevent 22 of the 35 banks followed by the investment house from outperforming the broader stock market, the analysts predicted.

Bank lending flattened out, and construction loans declined by 12.4% ($7.5 billion for the 35 banks) in the 12 months ended June 30.

But Salomon attributed part of that decline to heavy chargeoffs and foreclosures - and to refinancings that transformed construction loans into commercial mortgages.

At the same time nonperforming loans skyrocketed to 17% of commercial real estate loans, from only 11.2% nationwide - with deterioration afflicting money-center banks and banks in every region.

And more deterioration can be expected, particularly in California, for the rest of the year, the report stated.

The 11-year oversupply of office space that will push down rental rates and property values has not budged since Salomon last measured it a year ago. And the firm points to economic trends that contradict a widely held belief that demand for real estate is picking up.

"Significant employment declines in major metropolitan markets across the United States . . . have led to further increases in commercial real estate vacancy rates."

The Pick of the Litter

Salomon equity analyst Thomas H. Hanley had hinted at these conclusions in an earlier report predicting additional problems for First Chicago Corp.

In the latest message to investors, Mr. Hanley and his co-authors, including real estate specialist David Shulman, said only 13 of the 35 banks that Salomon tracks can be expected to outperform the market. These include Banc One Corp., Bancorp Hawaii, Bankers Trust New York Corp., Bank of New York Co., KeyCorp, CoreStates Financial Corp., Wachovia Corp., SunTrust Banks Inc., National City Corp., Norwest Corp., and Valley National Corp.

Pending mergers helped BankAmerica Corp. and Chemical Banking Corp. keep their place on the "outperform" list.

The report noted strong asset quality at J.P. Morgan & Co. but does not expect it to outperform the market because of factors other than real estate.

Economic trends continue to hurt northeastern banks' real estate prospects, with Worcester and Boston, Mass., emerging as the worst cities in the nation by employment measures, losing 7.1% and 5.1% of their jobs, respectively, in the 12 months ended midyear.

While the Farm Belt continued to hold up well, an acceleration of job losses in Southern California - particularly Los Angeles, which lost 55,100 jobs for a 1.3% decline - helped make that region another trouble spot. [Graph Omitted]

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