Despite the weakening economy and soaring vacancy rates in many property types, loan delinquencies and foreclosures have not risen to the point where lender portfolios are endangered. And lenders hope to keep it that way — by tightening lending standards, requiring higher cash reserves, demanding debt-coverage ratios and scrutinizing more carefully every aspect of a project — from scheduled lease rollovers to tenant credit ratings.
One byproduct of the tighter lending standards is a backlog of capital ready for investment in commercial real estate, says Thomas Jaekel, managing director of Chicago-based Cohen Financial LP, a commercial real estate investment firm that manages its own $550 million portfolio and $3 billion for correspondent lenders. “This industry has learned that you can't force capital into investments with less than good prospects,” Jaekel explains.
This is not to say that delinquencies won't rise. Commercial delinquencies typically lag a national recession by six to nine months, as corporate tenants lay off workers, unload office space and, in the worst cases, proceed into bankruptcy reorganization. Disciplined lending in the late 1990s and exceptionally low interest rates have prevented the kind of widespread collapse that occurred during the previous recession of the late 1980s.
With floating-rate loans dipping below 5%, for example, a building owner can experience 40% vacancy in some cases and still be cash-flow positive, says Brian Stoffers, managing director and COO at Houston-based L.J. Melody & Co., the mortgage origination division of Los Angeles-based CB Richard Ellis Inc.
So, even while consumers are racking up record delinquencies in home mortgages, commercial lenders are seeing only modest increases. The American Council of Life Insurers (ACLI) in Washington, D.C., reports that commercial mortgage loan delinquencies ticked up 0.05 of a percentage point to 0.27% from the first to the second quarter of 2002.
Further increases are still expected. In the troubled hotel sector, delinquencies stood at 0.39%, up from a mere 0.05% a year earlier. Retail registered 0.46%, up from 0.42% in the same period in 2001. (See table, page 40). “We expect delinquencies will continue to rise until about the second quarter of 2003 before leveling off,” predicts Jerry Crute Jr., associate director of investment research at ACLI.
However, he says, the rise must be kept in perspective: At the end of 2001, delinquencies were 0.12% — a record low. That was quite a drop from the early 1990s recession. In 1992, delinquencies tracked by ACLI peaked at a fearsome 7.5%. Foreclosures hit a high of 2.44%. In contrast, the foreclosure rate in the second quarter of 2002 was 0.08%.
Steven Graves, managing director of Principal Real Estate Investors LLC in Des Moines, Iowa, recalls that the firm's delinquency rate hit 5% in 1993. Today Principal, which was on track to make $2.7 billion in commercial loans in 2002, has a 0.25% delinquency rate. “Whenever loans are getting into trouble, we pay attention,” Graves explains. “This is a trend that bears close watch.”
In the Commercial Mortgage Backed Securities (CMBS) market, where investors accept more risk, the numbers tell a different story. (see table, left) According to Trepp LLC in New York, total delinquencies on CMBS loans in the five major sectors hit 1.82% in October, up from 1.09% a year earlier and 0.64% in October 2000. (Trepp defines a loan as delinquent when it is 30 days or more in arrears. A loan that is 90 days in arrears is defined as non-performing.)
Lodging-based securities, which saw delinquencies at 0.14% in 1998, had reached a delinquency rate of 4.61% in the latest October survey. Office was the healthiest segment, despite 20% plus vacancies in some markets — up from 0.41% in October 2001 to 0.72% in October 2002.
Lenders Aren't Panicking — Yet
Even with low interest rates and careful vetting by lenders, there are still catastrophes in the market. For example, in Chicago, JDL Development Corp., facing $35 million in overdue construction loans on four mixed-use projects, handed over the deeds to its lender, First Bank & Trust Co. of Illinois. Troubled First Bank & Trust, an aggressive lender to developers such as JDL in the late 1990s, reportedly now has $93 million in non-performing loans within a total commercial loan portfolio of $548 million.
It is also becoming more difficult for borrowers to obtain loans with high loan-to-value ratios. Deals that were financed at a 75% loan to value a year ago have shifted down 5 percentage points to about 70% in most cases, though the ratio falls to 60% or lower in sectors such as the hospitality industry. Chicago-based Tax Strategies Group LLC, which creates pools of commercial properties with fractional ownerships, recently closed an acquisition of an 180,000 sq. ft. shopping center near Las Vegas, anchored by a Lowe's Home Improvement store. With a high-credit tenant such as Lowe's in place, Tax Strategies was able to secure a loan for 75% of the property value from Cleveland-based KeyCorp, a division of KeyBank.
On the bright side, happy borrowers lately have seen spreads over benchmarks such as the 10-year Treasury actually narrowing. Edward Padilla, president and CEO of Bloomington, Minn.-based NorthMarq Capital Inc., which services a $11.5 billion commercial mortgage loan portfolio, has seen loans for both well-tenanted retail properties and apartments go under 1.5 percentage points above the approximate 4% Treasury benchmark. Office and retail deals are being completed at a spread of 2 percentage points.
“A year ago, the interest spread was 25 basis points higher and even more,” Padilla says. “For premium properties, I've noticed that lenders are willing to take less spread to get deals done.”
Higher Coverage Ratios More Common
Lenders concerned about the specter of delinquencies are paying particularly close attention to coverage ratios. According to Ross Berman, president and CEO of Chicago-based iCap Realty Advisors LLC, a typical property getting financed a year ago covered its debt 1.2 times with cash flow. The required ratio is closer to 1.3 times today, and in the case of hotels and other volatile sectors, it's risen as high as 1.5 times coverage.
Meanwhile, lenders are studying tenants with unrelenting skepticism. Berman tells the story of how iCap attempted to secure $60 million in construction financing for a 413,000 sq. ft. office building in Atlanta. The building was 76% pre-leased to a single corporate tenant, but that wasn't enough. No Atlanta bank would touch the deal. Berman is now trying to close the deal with a Chicago bank.
That situation is a sign of the times: When lenders have seen the implosion of companies such as Arthur Andersen, Enron and WorldCom, the idea of a single corporate tenant isn't so attractive. “There is a certain safety perceived now in multi-tenant buildings,” Berman concludes.
The rash of corporate failures has so jaded GMAC Commercial Mortgage Corp. that the huge lender is now putting much more emphasis on the collateral the building represents, rather than assuming that credit tenants will still be around to pay the rent. “We're reluctant to look just at the credit of a tenant,” says Barry Gersten, executive vice president for GMAC. “We get comfortable as lenders when there is a significant cushion between the debt level and the replacement value. An analysis of replacement is very important to us on every loan we make.”
To limit the possibility of delinquencies, lenders are also closely evaluating the borrowers' ability to cover ongoing overhead expenses such as leasing commissions and tenant improvements, which can amount to $1 per sq. ft. annually in many office buildings. Increasingly, the borrowers' reserves are being built into underwriting assumptions.
Underwriters are also injecting more “stress” into pro forma documents. “There have always been stress tests, but they're getting more focused now,” says John Fowler, executive managing director of Boston-based Holliday Fenoglio Fowler LP, which is one of the nation's largest real estate capital intermediaries. “If you've got an office building in say, Boston, with rents of $50 per sq. ft., but new rents in the marketplace are rolling over at $35, those rents have to be reflected in the underwriting.”
Another “what-if?” that lenders are plugging into their analyses is the effect of a war with Iraq. When the world's oil supplies are disrupted, prices on all commodities jump, inflation returns and interest rates climb.
“If interest rates move up you'll see some stress in portfolios of floating-rate loans,” predicts Jaekel of Cohen Financial.
According to Jaekel, an office building at just 80% occupancy may generate enough cash flow to service a loan at 4% or 5%. But if rates are raised to 8%, it probably can't service its debt. “That's why banks are nervous right now,” he says.
Cohen's current delinquency rate is a meager 0.04%. But every lender has a watch list, and the rolls of troubled borrowers are growing. “Our watch list contains about 30 properties now. A year ago it was just two properties. So we're on alert here,” says Padilla, who oversees a portfolio of 2,000 loans valued at $11.5 billion.
In such a tumultuous economy, many lenders are avoiding any long-term forecasting. Newark, N.J.-based Prudential Mortgage Capital Co., which has $32.5 billion in commercial real estate mortgages under management, relies on a three-year timeline to judge mortgage applications.
“What's important to us is ensuring that the cash-flow coming out of a property is secure and stable over the next three years,” says David Twardock, president at Prudential Mortgage. “Ultimately, the economy is going to start growing again. We just want to be sure that any borrower has the resources to get through this difficult period.”
H. Lee Murphy is a Chicago-based writer.
CMBS LOAN DELINQUENCY RATES
Delinquency rates across all the real estate sectors are on the rise, but lodging has experienced the most dramatic increase. CMBS delinquency rates for the lodging sector jumped from 2.20% in October 2001 to 4.61% in October 2002, largely due to declining occupancies and revenue per available room (RevPAR) in the sector.
|Property Type||Oct. '98||Oct. '99||Oct. '00||Oct. '01||Oct. '02|
|Source: Trepp LLC|
|*A loan is considered delinquent when it is more than 30 days late.|
COMMERCIAL DELINQUENCIES — LIFE INSURANCE COMPANIES
Delinquency rates on commercial mortgages held by life insurance companies rose by 0.05% in the second quarter, marking the second quarter in a row that rates increased.
|Property Type||Delinquency %||Yearly change||2Q change|
|Source: American Council of Life Insurers|