There’s little doubt that parts of the country are still reeling from the residential real estate collapse. Major banking reforms were instituted as banks closed their doors because of overinflated real estate prices, climbing unemployment rates and the inability of borrowers to make good on loans that were suddenly much larger than what their property was worth.
Now some Baton Rouge banks are carefully watching the commercial real estate market for signs that another nationwide collapse is imminent. About $3.4 trillion in commercial real estate loans are outstanding nationally with about $1.3 trillion projected to come due by the end of 2012, and a predicted wave of defaults could have disastrous results for lenders across the country.
Bradley Gremillion, senior vice president at American Gateway Bank, says he’s concerned about commercial real estate.
“We’re cognizant of the fact that there could be more pain to come,” he says. “We’re definitely taking steps to prepare for it. We want to help our customers and the bank weather the storm.”
The irony is that according to most lenders, federal regulations intended to prevent bad lending practices are at the heart of the issue. Commercial mortgage loans come up for renewal every three to five years. But this year, because of tightened underwriting standards and scrutiny by federal regulators combined with lower appraisals, some of those loans might not be renewable under their current terms.
Borrowers may be required to put more cash down to secure less favorable loan conditions, which many developers and investors might not be able to meet because of the current economic climate. The predicted result is a deluge of foreclosures, which would force more lenders to close their doors.
Baton Rouge, which is home to various community and regional banks, might not see as many foreclosures as other parts of the country because underwriting standards are comparatively high. That’s the position taken by Keith Short, who had served as the Baton Rouge market president for IberiaBank before leaving earlier this month to lead the company’s operations in two south Florida counties. While the lender recently acquired two failed banks in Florida, the local market has many stable commercial mortgage loans in its portfolio.
“With respect to client renewals, we haven’t changed our policies, procedures or parameters at all,” he says. “We haven’t changed our underwriting requirements.”
Branon Pesnell, an associate broker for Beau Box Commercial Real Estate, says some reductions are related to inflated prices after hurricanes Katrina and Gustav, but most can be attributed to rising capitalization, or “cap” rates. A cap rate is the ratio between a property’s annual net operating income and its original cost. The higher the cap rate, the lower the value of the property.
But a lower appraisal might not necessarily prevent borrowers from getting a loan. Some Baton Rouge lenders are practicing what Stirling Properties Vice President Dottie Tarleton, who works exclusively in retail real estate, calls “extend and pretend”—extending the terms of the original loan for one year instead of refinancing it for an additional three- to five-year period if certain underwriting factors present complications.
Gremillion interprets the FDIC guidelines to mean that all loans up for renewal must have a new appraisal. But that does not mean the bank cannot set up a “reasonable payment structure” between the borrower and the bank if the former has the proven financial capacity to continue making payments on the loan.
“We can work with a customer, because it’s not necessarily their fault the market changed and the value of their property went down,” he says.
But lenders also can be choosier about making loans. Short says IberiaBank, which does not have a high concentration of real estate in Baton Rouge, has seen increased commercial loan volume because developers are “shopping” for favorable loan terms, especially ones that do not require more equity.
“It’s been an opportunity for us,” he says. “A lot of developers and real estate companies are looking for a new home. The good news is that we can pick and choose who we do business with.”
In contrast, Gremillion says the volume of commercial real estate loans at American Gateway has decreased by 20% to 30%. While some of that can be blamed on the economy and a sluggish market, part of it is attributable to the bank’s new policy of selectivity regarding projects it chooses to finance.
“Our spigot is still on for commercial real estate lending. We’ve just really become very selective on the projects we are willing to get involved with,” he says. “Those projects have to be firing on all eight cylinders.”
His bank’s criteria include having a proven track record in commercial real estate, solid finances and a proposed project with practically all but a waiver guaranteeing success. The goal, Gremillion says, is to address any perceived obstacles a project might face up front to prevent default and foreclosure. That means site visits, regular updates and a thorough knowledge of the borrower’s financial and professional credentials.
While such increased scrutiny helps banks by keeping potentially troublesome assets off of their books and out of the sights of federal regulators, Pesnell says greater selectivity doesn’t help convince developers and investors sitting on the fence that the market is viable. Lenders might have the money to lend, but their list of underwriting requirements is long and offputting for those that might not have stellar credit or the cash equity to put down as security on the loan. The combination of lender and developer reluctance to buy into commercial real estate has kept the Baton Rouge market in gridlock. Breaking it might depend on “extend and pretend” deals and lower prices.
“Prices are going to have to come down to meet appraisals. There has to be a point of equilibrium,” Pesnell says. “Gridlock can’t last forever.”
Tarleton says foreclosures will occur because of stricter lending practices, but the Baton Rouge market just needs time to get back on its feet.
“I’ve been through this cycle before, and this too shall pass,” she says. “Some people will go belly up and fold, and some will be able to get through it. But it will get better.”
