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Commercial Real Estate Lending Challenges Banks in District


Michelle Clark Neely
Thursday, January 1, 2009

The importance of commercial real estate (CRE) lending to U.S. banks—especially community banks—is difficult to overstate. According to Federal Reserve data, the nation’s commercial banks hold almost half of U.S. CRE debt outstanding. CRE lending has especially edged up in significance at the nation’s community banks as other types of consumer and business lending have been lost to competitors. Now that conditions in commercial real estate sectors have deteriorated, banks face the possibility of significant losses.

Unlike the last commercial real estate crisis in the late 1980s/early 1990s, problems this time stem from a lack of demand rather than massive overbuilding that was spurred by tax law changes, among other factors. Coming on the heels of tremendous losses in residential real estate, the downturn in CRE markets is the proverbial second blow of the one-two punch that has staggered the nation’s banking industry.

Though not as severely affected as banks elsewhere, Eighth District banks have not been immune to real estate woes. Earnings have rebounded somewhat over the past few quarters (see “Profits Up at District Banks” on Page 3), but continued increases in nonperforming rates across all categories of CRE loans (i.e., construction and land development, multifamily, and nonfarm nonresidential) threaten further improvement. As of Sept. 30, CRE loans made up 43.5 percent of total bank loans at District banks yet accounted for 63.4 percent of all nonperforming loans.

The rapid deterioration in CRE portfolios over the past two years is illustrated in the figure. The ratio of nonperforming construction and land development (CLD) loans to total CLD loans (which includes residential as well as commercial construction) has skyrocketed since September 2007 and is approaching double digits. (It’s near 14 percent for U.S. peer banks.) The nonperforming rate for multifamily loans has more than tripled, while the rate for nonperforming nonfarm nonresidential loans has more than doubled over the same time period. CRE charge-off rates have similarly escalated, as has CRE other real estate owned (OREO).

According to forecasters, CRE market conditions are still a year or two away from turning around, which is typical of post-recession periods. Like unemployment, CRE vacancy rates are lagging indicators of economic activity. Further, unemployment and CRE vacancy rates tend to move together because demand for commercial real estate is highly dependent on employment growth.

The table shows third quarter 2009 vacancy rates for office and industrial space for six metropolitan areas in the District plus a national average. Also included are forecast peaks in these vacancy rates and the associated time period.


What a Difference Two Years Make: Nonperforming CRE Loans at District Banks

Nonperforming CRE Loans

SOURCE: Call Reports. Figures are from third quarter 2007 and third quarter 2009.

Office Sector

Third quarter office vacancy rates varied widely across the District, from a low of 6.2 percent in Little Rock to 17.6 percent in Memphis, and rates in all District metro areas except Memphis are at or lower than the national average of 15.7 percent. Fayetteville
is the only District metro area where the third quarter office vacancy rate (15.7 percent) was near its forecast peak (15.9 percent, occurring in the first quarter of 2010). For the other five metro areas in the table, peak office vacancy rates are at least a year away.

Industrial Sector

The industrial sector is weaker than the office sector in most District metro areas. All metro areas have industrial availability rates at or greater than the national average of 13.2 percent. As with office space, peak availability rates for industrial space are at least a year away in the District. Springfield is the exception here; its rate peaked in the third quarter and is expected to start coming down, while Memphis and Fayetteville have industrial availability rates in excess of 20 percent, and improvement is forecast to be more than one year away.

Multifamily Sector

Third quarter and forecast multifamily vacancy rates are available for Louisville, Memphis and St. Louis. Louisville and St. Louis currently have relatively low rates of 6.1 percent and 8 percent, respectively. Although the vacancy rate is near its expected peak in Louisville, the rate in St. Louis is forecast to rise to 11.3 percent by year-end 2011 before starting to decline. The multifamily vacancy rate in Memphis is substantially higher at 11.4 percent but is not expected to rise much above 12 percent.

Retail markets are weak everywhere. Though up-to-date retail data and forecasts are not available for District metro areas, anecdotal information suggests that this sector’s overhang won’t be absorbed for some time.

The trends occurring now in CRE markets are typical of post-recession periods. The degree to which the banking industry in the District and elsewhere ultimately suffers depends on how well problem credits are dealt with and how quickly jobs-producing economic growth picks up.


Vacancy Rates Are High and Climbing

MSA 3Q 2009 Office Forecast Peak Office 3Q 2009 Industrial Forecast Peak Industrial
Fayetteville, Ark. 15.70% 15.90% (1Q 2010) 20.10% 21.00% (2Q 2011)
Little Rock 6.2 11.9 (4Q 2011) 16 16.7 (3Q 2010)
Louisville 12.7 14.3 (4Q 2010) 14.2 15.3 (1Q 2012)
Memphis 17.6 21.9 (2Q 2011) 20.7 22.8 (1Q 2011)
St. Louis 15.4 19.6 (1Q 2011) 13.2 15.9 (4Q 2010)
Springfield, Mo. 13.3 16.6 (1Q 2012) 14.2 14.2 (3Q 2009)
National Average 15.7 18.4 (1Q 2011) 13.2 15.4 (4Q 2010)

SOURCE: CBRE Econometric Advisors