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Bank Default Rates on CRE Loans Projected to Hit 4% in Fourth Quarter

Deterioration in property cash flow, erosion of reserves to cover shortfalls in debt service and little credit to refinance maturing mortgages all contributed to a higher default rate on commercial real estate mortgages held by depository institutions in the third quarter. That’s according to New York-based Real Estate Econometrics, which analyzed data recently published by the Federal Deposit Insurance Corp. (FDIC).

The national default rate rose to 3.4% in the third quarter, up from 2.88% in the second quarter. Meanwhile, the national multifamily mortgage default rate jumped from 3.14% to 3.58% over the same period.

The dollar volume of bank-held commercial mortgage loans 90 days or more past due increased from $3.5 billion in the second quarter to $4.4 billion in the third quarter. Over the same period, delinquent commercial mortgages 30 to 89 days past due rose from $12.7 billion to $13.2 billion.

“Mortgages originated in 2006 and 2007 are experiencing the most significant shortfalls in current cash flow relative to current debt service obligations,” according to the New York-based researchers report entitled Fourth Quarter 2009 Commercial Mortgage Default Projections. “This is a result of the large number of mortgages underwritten to aggressively forecast prospective cash flow rather than to in-place cash flow during this period.”

As much of this aggressively underwritten debt matures in 2011 and 2012, the 2006 and 2007 vintage mortgages will require larger balance adjustments as a result of high loan-to-value ratios and weak debt service coverage, even if credit conditions ease significantly, according to the report.

While many loans that originated five to 10 years ago are currently able to meet debt service obligations, refinancing these performing loans as they come due may present more of a challenge as lenders shift away from commercial real estate and toward lending only where relationships exist, according to Real Estate Econometrics.

The FDIC’s policy changes that will give lenders the ability to keep performing underwater loans on their books have impacted the forecasted default rate slightly, from 4.1% at year-end 2009 to 4%. However, the national default rate is still projected to continue rising, to 5.2% by the end of 2010 before peaking at 5.3% in 2011.

Meanwhile, the national default rate for multifamily mortgages is projected to rise to 4.3% in the fourth quarter of 2009 before peaking at 5.3% in 2010.

Across 4,554 institutions with commercial real estate concentrations of 10% or more, the mean default rate was 2.6%. The median default rate was significantly lower, however, at 1.4%. “The skew in the distribution reflects a relatively smaller number of institutions with very high default rates,” according to the report.

In spite of prevailing market opinion, banks with high concentrations of commercial real estate mortgages do not necessarily have high default rates.

“In fact, we can observe that some lenders with high concentrations are experiencing relatively low default rates; others with similar geographic and size profiles are experiencing higher default rates,” says Sam Chandan, president and chief economist for Real Estate Econometrics. “Digging deeper than the concentration measure, quality of loans, risk management practices, and other institutional factors are all important for a bank's default and loss experience.”

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