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Another Bubble?

Orange County Business Journal

By DAN BEIGHLEY - 6/15/2009

Local banks are bracing for what they believe to be a coming wave of problems with commercial real estate loans.

Scores of loans made in the heyday of lending about five years ago are set to mature in the coming year, leaving a number of real estate owners owing more than their properties are worth.

Bankers fear their borrowers won’t be able to make up for the lost value with additional cash, which would be needed to keep the terms of the loans.

Some fear the borrowers will walk away, leaving the lenders as landlords.

It’s hard to say exactly how many loans will be affected, according to local bankers.

“The problem is huge,” said Glenn Gray, chief executive of Sunwest Bank in Tustin. “Hundreds of properties around the county could be affected.”

Nationwide, commercial mortgage-backed securities—loans on buildings that are bundled together and then sold to investors—are starting to fall apart. According to Deutsche Bank AG, the total CMBS delinquency rate could be greater than 3.5% by year’s end and as high as 6% by 2010. That’s a sharp turn of events for a sector that’s been known traditionally as a safe investment.

And it’s a blow to many local banks that thought they escaped the subprime home mortgage mess that crippled other lenders.

But, as with housing loans, large amounts of commercial loans were packaged and resold to hungry investors, who were less diligent about checking the health of the loans or didn’t foresee the extent of the commercial real estate downturn.

Now that investor money largely has dried up.

Fewer funds and a lack of investors also will make it harder to renew the loans, according to Scott Connella, market president for San Francisco-based Union Bank NA, part of Japan’s Mitsubishi UFJ Financial Group Inc.

Most expect to see a local bank go under from bad commercial real estate loans.

That could actually work out in the favor of stronger local banks, including Sunwest and CommerceWest Bank NA in Irvine, which have been approved by the Federal Deposit Insurance Corp. to buy other banks.

CommerceWest, with $236 million in assets as of March 31, is buying Discovery Bancorp, which has $170 million in assets.

The San Marcos-based bank reported a net loss of $5.4 million for 2008 driven by too many “nonaccrual loans” on the personal and commercial sides, according to its quarterly report.

The $10 million deal, expected to close in the third quarter, stands to move CommerceWest from the No. 12 spot among the largest locally based banks, into the top five (see list, page 22).

Commercial loans are also expected to be an issue for larger banks such as San Francisco-based Wells Fargo & Co. and Charlotte, N.C.-based Bank of America Corp., which both were unavailable for comment.

But how big an issue is up for debate.

Funds from the government stimulus package should help ease things by providing more flexibility with making loan modifications, according to Ivo Tjan, chief executive of CommerceWest Bank.

More flexibility would make banks better able to renegotiate with borrowers, Tjan said.

“We don’t see any mass explosion with commercial real estate like some people do,” he said. “We’re better prepared to handle this than we were before the problem in the housing market.”

The prospects of an effective government stimulus have caused Tjan to improve his outlook in the last month and a half.

CommerceWest initially forecast commercial real estate values to fall 40% next year. It’s now looking for a 25% decline.

Its outlook on property capitalization rates, which measure how much immediate income a property generates relative to its cost, was lowered to 10% from about 12%, reflecting a stronger market.

Stronger Banks

Many banks also have been successfully raising money to defend against potential problems, Tjan said.

How well a bank holds up largely will have to do with the success of its underwriting standards and its capital cushion.

Those who stayed conservative in their lending will hold out best, according to Sunwest’s Gray.

“We’ll be fine,” he said. “We used strict guidelines (and looked) at the properties as if we were already an owner.”

Of Sunwest’s $166 million in loans as of March 31, about $76 million was in commercial real estate, according to government data.

CommerceWest had about $138 million in loans at the end of the first quarter, of which nearly $52 million was commercial real estate.

Like many bankers, Tjan says commercial real estate loans made to owners that occupy the buildings are less risky.

“There’s more incentive for the business to keep its home,” he said.

Union Bank also has about 40% of its local loans in commercial real estate, most of them owner occupied, according to Connella.

“We’re not so much nervous about these loans,” he said.

Union Bank made most of its loans with seven- and 10-year maturity schedules, and at a gradual pace, according to Connella, giving the bank a few more years of cushion before the loans are due to be reset.

Banks that did a rash of loans with five-year maturity schedules will be hardest hit, he said.

Building Types

Some building types are in more trouble than others, as well.

Orange County may be in better shape than some markets because it has less exposure to industrial-type properties that many are fretting over.

But retail properties may pose a problem for some as the down economy is pushing stores out of business without a ready crop of retailers to replace them, Connella said.

Nationwide, delinquencies on retail loans made up $1.7 billion of the total $6.2 billion of all delinquent commercial loans, according to Fitch Ratings Ltd. And the agency expects defaults on retail loans to go higher.

That could provide opportunities for small business owners to buy empty buildings on the cheap.

The Small Business Administration’s 504 loan program also is set to help troubled commercial real estate loans.

The no-fee loans let the borrower put down only 10%, while the government puts up 40%, and the bank provides the rest of the financing. Many bankers have been encouraging business owners to buy buildings under the loan program.

“We rarely see deals look as good,” Tjan said. “The next 12 to 18 months will be a good buying opportunity.”