All is Fair Game

On the one hand, while CRE is a bread-and-butter product for community banks and thrifts, "it is also true that, in too many cases, concentrations in commercial real estate have led to significant losses and failures of community banks. The vast majority of community bank failures over the past three years involved commercial real estate to some degree, and in most of these cases, that exposure was the primary reason for failure," Curry said.

That fact is evident this month when regulators shut down Security Exchange Bank in Marietta, GA, which had the highest percentage of distressed commercial real estate assets in the country compared to total assets.

As of March 31, Security Exchange Bank had $151 million in total assets and CRE lending did, in fact, make up 37% of its total loan portfolio.

However, 37% of Security Exchange Bank's total assets also were delinquent CRE loans or foreclosed CRE properties. The bank held $38.5 million of foreclosed real estate.

The Georgia Department of Banking and Finance closed the bank and appointed the Federal Deposit Insurance Corp. (FDIC) as receiver, which entered into a purchase and assumption agreement with Fidelity Bank in Atlanta, Georgia, to assume all of the deposits of Security Exchange Bank two branches.

The FDIC and Fidelity Bank also entered into a loss-share transaction on $102.8 million of Security Exchange Bank's assets. Fidelity Bank will share in the losses on the asset pools covered under the loss-share agreement.

"That's not to say that CRE concentrations threaten the viability of all community institutions. Far from it," Curry said. "The overwhelming majority of the banks and thrifts we supervise are managing their CRE exposures very well. Our message to these institutions is clear and consistent: continue to work with borrowers who face difficulties, but also recognize and address problem credits by maintaining appropriate loan loss reserves and taking appropriate charge-offs when repayment is unlikely."

Outlook: The Good and the Bad

Curry told conference attendees there is both good and bad news in the outlook for commercial real estate.

"We see real and tangible signs of improvement in CRE markets and CRE loan performance, and that gives us a reason for cautious optimism," he said.

On the positive side, demand for multifamily housing is picking up, in no small part because homeownership rates dropped as the economy turned down, but supply is growing as well. Demand for office buildings is growing steadily, but moderately, reflecting the slow growth in employment. Demand for retail and warehouse space is also improving, due to increased consumption, but weakness in the housing market and technological advances that favor internet sales over retail stores are hurting some segments of the market.

"However, as a supervisor, I have to be more concerned about the very strong headwinds these markets and their lenders still face. In fact, while we are seeing improvements in some of the fundamentals, even the positive trends come with qualifications and risks," Curry said.

"Although demand for CRE space is increasing, it remains soft relative to historical norms. Thus while vacancy rates have improved, they are likely to remain elevated in many markets over the next couple of years," he added. "Rental rates and net operating income are well below peak levels, and net operating income is expected to continue to decline nationally for the next year or two for warehouse, office, and retail space. Many leases signed during the boom will be renewed with lower rents, and that will continue to put downward pressure on net operating income."

"Despite the remaining obstacles, we know the environment will eventually improve," Curry said. "Booms don't last, and bubbles inevitably burst. When the economy is growing, demand for all kinds of commercial real estate, from office buildings to warehouses, increases quickly, and rental income begins to grow rapidly. At that point, it will be tempting for lenders to grow their CRE portfolios. Again, this is an essential product for community banks, and CRE growth can lead to very healthy-looking profits in the short run."

"But the short run is, well, short," Curry said. "Sooner or later, the market turns, and when it does, lenders with outsized concentrations, particularly those who grew their portfolios rapidly, will experience the same painful adjustments and losses that we are working our way through right now. It does lenders little good to rack up record profits during the boom if they have to give them all back and more during the bust."

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