During the 1980s, a unique combination of increasing demand for space, aggressive and readily available capital, a leverage mentality, and unbridled optimism produced the strongest real estate boom in the nation's history.

Today, however, property performance at 50% to 60% of projections that were made just a few years ago is not uncommon. Liquidity has left the market and is unlikely to return for several years. Also, many borrowers are effectively insolvent.

Given these conditions, only a gradual, painful recovery over the next several years can realistically be expected.

Regulatory Pressure

For the banking community, the fundamental change and restructuring are far from over. And banks continue to face unparalleled regulatory pressure and scrutiny from examiners.

While cost-cutting programs and the strength of the stock market have given many banks relief from questions of solvency, problems remain in bank real estate portfolios.

However successful the properties, few maturing loans can be paid down. Stabilization of development properties continues to require more capital than planned, with the return on new capital often difficult to measure. And loans restructured as recently as 12 months ago continue to go back on the nonperforming lists.

Knowledge is Power

Given the magnitude of than problems, senior management is facing an extremely difficult period. To manage a bank real estate portfolio effectively in this environment requires the highest-quality information available about the nature and size of portfolio problems, and about the potential for future problems. Specifically, senior management needs:

* A realistic, market-driven assessment of the real estate portfolio that includes a comprehensive inventory, a measure of value and potential losses, and an assessment of alternatives.

* Accurate prediction of problems. Management must have a mechanism to identify problems that have not yet surfaced, as well as the ability to predict the timing of problems already identified.

* Effective planning and measurement of success. Many banks continue to react (or overreact) as problems arise, and few have achievable objectives for the next three years against which performance can be measured.

Strategic Audits

To meet this need for unbiased, realistic information, a number of banks have undertaken strategic audits of their realty portfolios.

A strategic audit is not an accounting audit or an appraisal. It is a review of the portfolio as a whole, and the major assets therein, geared to providing information to senior management in a form useful in making decisions regarding the short-term and longer-term management of the portfolio.

It is typically performed by an independent consulting firm with expertise in portfolio evaluation and strategic planning, as well as a hands-on knowledge of the realty and capital markets.

The three basic components of a strategic audit of a bank real estate portfolio are: a comprehensive inventory and segmentation analysis, a management and organizational review, and the creation of an "action plan."

Analysis and Detailed Reviews

The comprehensive inventory and segmentation analysis can take a variety of forms, ranging from an analysis of I%e pool; of assets to a detailed review of each asset in the portfolio. The form it takes win depend on the size and nature of the bank's real estate portfolio, as well as the availability and accuracy of existing information. These analyses share the following common elements:

* Creation of a management data base. The first step in analyzing a portfolio is to create a comprehensive management data base that includes key information on each asset, such as detailed information on the loan, the borrower, guarantees, and the nature, status, and performance of the collateral.

* Portfolio segmentation analysis. Using the data base, the portfolio is segmented and analyzed based on all the key characteristics, such as loan size, maturity, performance history, property type and location, status of development, guarantees, and interest rate. The purpose is to create pools of assets with similar risk, return, and liquidity characteristics.

* Analysis of exposure and risk. The next step is to analyze exposure and risk in the portfolio. On a segment-by-segment basis, this analysis takes into account such factors as market conditions, collateral value, availability of alternative sources of capital, and the condition of the borrowers.

It also quantifies the amount and timing of expected losses from both identified problems and potential problems. Finding potential problems is the most difficult task, but often the most helpful to management.

By structuring the data base properly, analyses of coming maturities, lease rollovers, and other property statistics can be very useful in predicting future nonperforming assets long before they cease to perform.

Management Review

After the portfolio inventory and segmentation analysis, a management and organizational review is undertaken. It is similar to a review by a large management consulting firm, except that it is highly "asset focused."

Based on the needs of the particular bank, this review can be as simple as an overview of management effectiveness in addressing and solving problems in the portfolio, or as detailed as a review of organizational structure, management information systems, personnel, asset management and property disposition capabilities, and planning and performance evaluation systems.

Focused interviews with loan officers and senior real estate management are the primary means of obtaining information on portfolio management.

These interviews are also extremely useful in confirming and augmenting the information in the portfolio data base. Topics covered in a typical loan officer interview include individual and group goals, loan workout procedures, and the status of major relationships and key assets.

A Plan of Action

After the analyses and interviews have been conducted, the action plan is developed. It is an overall plan that includes a series of clearly articulated steps designed to address key problems and requirements of the portfolio. The plan includes:

* Definition of clear and consistent objectives. Often the objectives used to measure management performance and communicate with the board and shareholders are not realistic or are not clear and consistent so that line management can be effectively motivated. These objectives may be conflicting, such as "minimize losses" and "reduce the level of nonperforming assets quickly." And numerical objectives do not resolve the conflict. * Creation of "action steps" to solve problems in the portfolio and meet management's objectives. Action steps are discrete, measurable programs that are focused on specific problems or objectives. They are designed so that the minimum number of steps can have the greatest positive impact on the portfolio.

Asset-related action steps may include intensive asset management, dispositions, restructuring nonperforming loans, and pursuing foreclosure and/or guarantees.

Management-oriented action steps can include building in-house asset management capabilities, modifying organizational structure, and creating a management information system that is geared to flagging real estate problems before they become serious.

* Analysis of the financial impact of implementing the action steps. For each action step, an analysis is performed to identify the income and expense impact in the current year, as well as in future years, and to evaluate that action step against alternatives.

For example, one action step might be to sell a package of nonperforming loans rather than pursue foreclosure, manage the properties, and ultimately sell them.

The financial analysis would identify the expected loss on a sale of the loans, the costs associated with delivering the necessary asset management services if a foreclosure is pursued, and the break-even price at which the loans can be sold.

Interactive Process

The development of the action plan is an interactive process involving both management and the consultant. There is no one best plan. In fact, there are only two critical elements.

First, senior management must sign off on the objectives. Second, both the objectives and action steps must be consistent with the bank's portfolio and conditions in the real estate and capital markets.

Given the uncertainty that is likely to continue in the commercial real estate markets for several years, senior management has a critical need for unbiased information regarding the timing and magnitude Of problems in the real estate portfolio and alternatives available to address those Problems.

Mr. Sherman is a managing director and partner of the Harlan Co., a real estate consultant in New York.

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