I was at a banking conference last week and there were three CEOs from California banks (“community banks” – $800 million to $6 billion in assets) on a panel discussing Southern California CRE credit trends. Here’s a summary of their thoughts and observations:
– We’re in the third or fourth inning of the downside of the (general) credit cycle; it will get meaningfully worse before it gets better.
– Bottom of the cycle/Recovery will be late-2009/early-2010.
– There’s a notable bifurcation in the CRE market. In general, properties closer to the coast (10 miles) and/or surrounded by “established” neighborhoods are doing pretty well, although problems are expected to crop up. Properties further from the coast – Inland Empire, Murietta, Temecula, East SD County, East Chula Vista, etc. – are struggling and it will get much worse; it will be like the early-90s in these areas.
– CRE in the coastal/established areas will have problems but not as bad as the early-90s due to: (1) A more diversified economy – that is, we won’t have the same proportion of people simply leaving the state as when the defense industry left the state in the early-90s, and (2) Less overbuilding this time around – the early-90s CRE meltdown was exacerbated by dramatic overbuilt conditions throughout SoCal.
– The CRE-oriented REITS with lots of exposure to Class A office towers in Orange County will have big problems as this market is in shambles due to all the high-end mortgage broker-related space available.
These three bankers were all operating their banks during the early-90s and survived without needing to be recapitalized. They are generally thought of as relatively conservative underwriters.
Now, there is a distinction that needs to be made between existing CRE and CRE that’s under construction or recently completed and not leased up. Probably anything that’s under construction or recently completed (and not leased up) is a bad deal for the bank, almost regardless of its location.
The main thing that separates CRE from SFR is that, ultimately, there’s gotta be a debt coverage ratio when the loan is underwritten, generally between 1.1x and 1.2x (now it’s almost exclusively 1.2x because banks are tightening up on underwriting). And the minimum LTV has generally been 85%, even during the boom times, although cap rates have been very (re: too) low. BUT, the debt coverage ratio puts a cap on how much the bank is willing to lend regardless of what value gets generated from the cap rate. So, things got crazy in CRE, but not nearly as crazy as SFR, because there is real income involved (although it will certainly decline for the next few years) and there is real equity involved (again, this too will almost certainly decline in aggregate).
So, my guess is that we’ll see the coastal/established properties, in aggregate, lose some tenants and have to re-lease at lower rates, plus cap rates will inch up and net/net many of these properties will be underwater for a couple of years, but not REALLY underwater. Most will continue to make their interest payments, some loans will need to get restructured (with attendant losses for the banks) and some will get foreclosed, with larger losses for the banks. But – and I could be wrong – while I see impending pain and discomfort, I don’t foresee a total disaster in this property type.
But the stuff in the Inland Empire, East County, etc… that will be a bloodbath largely because the customers (the people who are in foreclosure and/or never moved into their homes) simply aren’t there to support the businesses.
