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Home > Bank Resources > Bank Resources Publications > SRC Insights > 2002 > Fourth Quarter

SRC Insights: Fourth Quarter 2002

Trends in Commercial Real Estate

by Eddy Hsiao, Senior Examiner and Vince Poppa, Special Studies Manager

In recent months, many economists and analysts have changed their initial optimistic views on the pace of economic recovery. The popular prediction that the economy would pick up in late 2002 or early 2003 may not come to fruition. Economic reports for various business sectors reflect mixed results and forecasts are embedded with many uncertainties. However, one area where analysts are in agreement is the gloomy outlook for the commercial real estate (CRE) market. This article will show how the regional CRE market compares to that of the nation and how CRE and commercial and industrial (C&I) loan performance measures for Third District banks compare to the national averages.

A survey of real estate trends conducted by the FDIC for the period between January 2002 and June 2002 indicates that the nation's real estate markets continued to deteriorate. The deterioration trends appear in higher vacancy rates, lower market prices, higher rent rate concessions, and a slower pace of sales. The western region was the weakest, specifically in San Francisco, where many institutions have high concentrations of CRE loans. Other markets that reflected over 20 percent vacancy rates included Columbus, Detroit, Dallas/Ft. Worth, Salt Lake City, Las Vegas, Jacksonville, Austin, Baltimore, and Atlanta. While the Philadelphia region has not weakened as much as other regions, it has not been spared entirely.

PHILADELPHIA REGION CRE¹

Philadelphia Metropolitan Office Market

The Philadelphia metropolitan region consists of nine counties in Pennsylvania, New Jersey, and Delaware, and covers 19 submarkets listed in Table 1. The office market consists of over 118 million square feet of multi-tenant office space in 1,480 buildings.

While some submarkets have reported a decline in office vacancy rates, overall market vacancy continues to rise. The Conshohocken market had the highest increase in the vacancy rate, with vacancies jumping from 15.1 percent at the end of the first quarter to 25.9 percent at the end of the second quarter. The delivery of completed offices may have been a factor in the sharp increase in the vacancy rate. For instance, at the end of the first quarter, there were 685,000 square feet of office space under construction in Conshohocken, with only 340,000 square feet remaining under construction at the end of the second quarter.

As shown in Table 2, the vacancy indices of the Philadelphia and Wilmington metropolitan and suburban regions compared favorably to those of the nation. However, the vacancy rate for downtown Philadelphia approached the national average of 12.1 percent, and downtown Wilmington's vacancy rate exceeded that of the nation for the second consecutive quarter. The significant increase in vacancy for downtown Wilmington reflects corporate downsizing and relocations. Wilmington has a high level of office employment in the finance, insurance, and real estate sectors. Their problems, coupled with stagnant economic conditions and a depressed stock market, have had a significant negative effect on the office employment in Wilmington. Other than miscellaneous investing and trust business areas, which had positive annual growth, banks, mortgage companies, insurance agents, and securities firms all reported negative employment growth.

Philadelphia Metropolitan Industrial Market

The Philadelphia metropolitan industrial market consists of approximately 260 million square feet of industrial space in over 1,000 manufacturing and warehouse buildings. As shown in Chart 1, Delaware, Lehigh Valley, and Camden Counties experienced vacancy declines, while the rest of the submarkets experienced increasing vacancy rates. The Lehigh Valley and Philadelphia markets had the highest vacancy rates in the region, at 15.7 percent and 15.2 percent, respectively. The Lehigh Valley market continues to lead the area in new construction despite its high vacancy rate, with 763,820 square feet under construction. The average vacancy rate of 10.7 percent for the region was slightly below the national average of 11.2 percent, but up from the first quarter 2002 level of 9.4 percent.

A rise in the average lease rate during 2001 exacerbated the increased overall vacancy rate for the Philadelphia region. However, the average lease rate appeared to have dropped slightly in the second quarter in response to higher vacancy rates, with five out of the ten counties reporting a decline in the average lease rate.

CRE AND CREDIT RISK
Regulators are concerned that the increased concentration of CRE loans, combined with deteriorating CRE markets, might lead to heightened credit risk exposures. However, regulators also have noted that the underwriting standards generally are better than in the previous recession, during which the CRE loans took a heavy blow. Nonetheless, many de novo institutions have unseasoned loan portfolios and staff who may not have experienced adverse economic conditions.

Concerns about credit risk at Third District banks are not as high as at banks elsewhere in the nation, because the declining CRE market conditions in the District do not appear to be as severe. Many Third District banks are requiring personal guarantees for CRE credit, and most bankers still feel more comfortable making CRE loans than C&I loans, which historically have had greater inherent loss exposures.

PORTFOLIO COMPOSITION
Charts 2 and 3 depict the loan mixes for the Third District and the nation in 1991, at the height of the last recession, and in the second quarter of 2002. Third District loan compositions exclude special purpose banks (i.e., credit card banks), subsidiary banks of out-of-district bank holding companies, and banks that merged out of the District since 1991, thus providing a truer picture of the changes in the loan composition.

As shown in Chart 2, Third District mortgage loans represented 34.2 percent of the portfolio in 1991, but only 29.7 percent today. The major reason for the decline is that management now sells mortgage loans in the secondary market more quickly than in the past, especially during the recent refinancing booms. Installment loans have declined similarly, falling from 13.4 percent to 8.1 percent of total loans. In contrast, CRE, including construction loans, grew from 22.4 percent to 35.6 percent during this period, and the CRE portfolio now exceeds the residential mortgage loan portfolio.

Chart 2. Loan Mix—Third District

For the nation, the shift in loan portfolio composition, as shown in Chart 3, is not as pronounced, since only a small change took place since 1991. CRE, including construction loans, grew modestly from 18.3 percent of total loans at the end of 1991 to 20.4 percent at the end of the second quarter 2002. Although the percentage of C&I loans declined from 27.2 percent to 23.9 percent during this period, they still comprise the largest loan component. Compared to the nation, the Third District appears to have a lower credit risk profile, with a larger portion of its loan portfolio secured.

Chart 3. Loan Mix—Nation

DELINQUENCY TRENDS
Charts 4 through 7 show that the quality of CRE loans, as measured by delinquency and charge-offs, surpasses that of C&I loans and that the quality of both CRE and C&I loans in the District is generally better than nationwide averages. Noncurrent CRE and C&I loans reached record highs at the depth of the recession in 1991. However, the nation's noncurrent CRE loan level of 8.0 percent was nearly double the C&I loan level of 4.4 percent. CRE loan quality has remained fairly sound since 1997.

As shown in Chart 4, noncurrent CRE loans in the nation fell dramatically between 1991 and 1995 and continued to decline to a record low of .71 percent in 1999. In 1998, noncurrent CRE loans fell below 1.0 percent of the portfolio and, to date, have not surpassed this level.

For the Third District, the level of noncurrent CRE loans was not as high as the nation's in 1991, only reaching 2.8 percent. The Third District exhibited a gradual improvement in CRE credit quality and reached a record low of .62 percent in 2000. In the second quarter of 2002, the Third District's noncurrent CRE loan level of .79 percent remained below the nation's average of .95 percent.

As noted earlier, some regions within the nation are experiencing problems with CRE and many analysts are concerned with the potential deterioration in CRE credits. However, there are currently no signs of significant deterioration in either the Third District or the nation. Nevertheless, based on the slow economic recovery and the overall increase in vacancy rates, the potential for lower quality in CRE loans exists.

As would be expected, as shown in Chart 5, CRE net charge-offs in both the Third District and the nation followed the same downward trend as noncurrent CRE loans from 1992 to the late 1990s. The CRE charge-off rate has been relatively low since 1996, but has increased modestly in recent quarters.

Although noncurrent C&I loans for the nation reached 4.4 percent in 1991, the Third District was not far behind at 3.6 percent. As shown in Chart 6, the nation's noncurrent C&I loan level improved more rapidly than the District's after the 1991 recession, but it has been rising since 1997. In the last 2 ½ years, nationwide C&I loans have deteriorated considerably, and noncurrent C&I loans represented 2.9 percent of outstandings in the second quarter of 2002, above the 2.0 percent level last seen in 1993.

Growth in noncurrent C&I loans for the nation has slowed somewhat, rising by 26.7 percent for the first six months of 2002, compared to an increase of 35.2 percent in 2001. Most of the growth in noncurrent loans occurred in large banks' C&I loan portfolios. In the last two years, the U.S. financial system has suffered a sharp run-up in corporate bond defaults, business failures, and investor losses. The fallout in the telecom industry, one of the most debt-laden sectors, exacerbated the negative effect on the financial sector. In the past six months, defaults in the telecommunications industry in England, corporate defaults in Argentina, and some major bankruptcies in the U.S. continued to plague the largest U.S. financial institutions. Noncurrent C&I loans to non-U.S. addressees accounted for 84 percent of the increase in noncurrent C&I loans in the first half of this year.

As shown in Chart 6, the Third District's C&I loan performance in recent years has been better than the nationwide average. Third District noncurrent C&I loans were high in the early 1990s and improvement lagged the nation's until 1998. However, since 1998 Third District C&I credit quality has stabilized, while the national average has deteriorated rapidly. Noncurrent C&I loans in the Third District have remained around 1.0 percent since 1998, and were .94 percent in the second quarter 2002.

As shown in Chart 7, C&I net charge-offs reached a high for the nation of 1.8 percent in 1991, falling rapidly for the next three years to reach lows of approximately .30 percent between 1994 and 1997. In 1998, C&I losses began to rise again, and annualized C&I losses reached 1.6 percent of outstandings in the second quarter of 2002, close to the record high set in 1991.

C&I losses for the Third District reached a record low of .17 percent in 1996. Although increasing since then, they have remained below .50 percent in the past two years, falling to .34 percent in the first six months of 2002.

FINAL THOUGHTS
The prospects for commercial real estate loans are mixed, with potential deterioration due to rising vacancy rates and the generally weakened economic condition in the nation. However, the credit risk level for the Third District is not as high as in other parts of the country. The Third District does have a higher concentration of CRE loans than the national average. However, with the exception of a few submarkets, the Philadelphia region does not have the level of office vacancy rates experienced in the West. Bankers in the Third District remain willing to extend CRE loans, due in part to the real estate collateral support in case of liquidation. Consequently, CRE loans continue to outperform C&I loans, the dominant loan category for the nation.

Nonetheless, deterioration in loan quality has started to surface, and examiners have noted some slippage in credit underwriting and appraisal reviews. Given the ever-present economic uncertainty, the influx of bank deposits from the capital markets, and intense competition, it is important for institutions to have proper underwriting standards and adequate risk management processes for CRE lending.

Some areas for close attention are the reasonableness and validity of appraisals and the financial condition of borrowers. In addition, underwriting processes should ensure appropriate monitoring of concentrations and set individual and portfolio limits on speculative construction lending. A future article in SRC Insights will review these and other best practices in CRE lending.

• ¹ A significant source of statistical information for this section of the article was CB Richard Ellis Services, Inc & Torto Wheaton Research.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.