Commercial Real Estate Lending in the 1990s: One Veteran's Story

By Weld, Doug | The Journal of Lending & Credit Risk Management, April 1997 | Go to article overview

Commercial Real Estate Lending in the 1990s: One Veteran's Story


Weld, Doug, The Journal of Lending & Credit Risk Management


In writing about issues concerning strategies in commercial real estate underwriting, many old and somewhat trite sayings come to mind:

* If you miscalculate, value inflation will correct the deficit (1970s).

* Interest rates can't go above 10% - the markets would collapse (1980s).

* Everyone knows that real estate values never go down, at least not by much and not for long (1990s).

There are also these timeless favorites:

* The location isn't the best, but the borrower (or tenant) is the best.

* Three other banks (list your three dearest local competitors) have already bid on the deal; it must be o.k., and if we don't respond now, we'll lose the deal.

* I know the developer's a little light on total cash in the deal (say "sweat equity" or no cash) but he/she is our best (or oldest) borrower.

* The market data may be important, but the developer has been doing these types of projects for at least 25 years (insert 50-100 years for old-timers), so he or she must know the market better than we do.

* I know it's a nonrecourse loan, but that's the new market and we get paid for taking risks, don't we?

While all lending is subject to cyclical swings of the marketplace, the cycles have been most erratic and severe in commercial real estate. This product can bring great pleasure and also great pain to the local chief financial officer because, more than any other product, commercial real estate can create quick fee income for the balance sheet and horrendous losses for the portfolio.

In Tokai Bank's experience, its problem commercial real estate loans stemmed from 1987 to 1989, when the real estate lending market was at the peak of the up cycle. It's at the very peak of the lending cycle that problems are created, not at the down side of the market. A review of the large commercial banks in the western U.S. shows that a majority of the dollar volume of past losses occurred in commercial real estate portfolios. With credit size ranging from $5 million to $50 million and losses often at 15-50% of the original principal amount of the credit, commercial real estate can wreak havoc on profits, loan loss reserves, and capital.

I have been a banker during the last three down cycles in the commercial real estate business in California and a veteran (or survivor) of the trench wars. The lessons learned can benefit lenders in all economies, regardless of the stage of the market cycle. While not intended as a treatise on underwriting commercial real estate, this article seeks to provide an overview for commercial real estate activities.

The Situation

My true trial by fire came in 1990 when I became chief credit officer of Tokai Bank. After the first few months in the job and after my first regulatory exam, it was clear that:

* Our appraisal process needed help.

* The loan grading system was not what it should be.

* The loan policy manual was severely in need of an update.

* The loan loss reserve system needed to be refined.

* Some of the bank's internal reports needed some adjustment.

It was clear to me that, before my next exam, I had quite a few tasks to accomplish. While the bank knew it had some concentration in commercial real estate loans, later review would indicate that the actual concentration was more than 85% of total assets. In addition, it came to light that the average credit size was more than $4.5 million and the average commercial real estate loan was in excess of $5 million.

As fate would have it, at the same time I was attempting to deal with these issues, I began receiving data that the market was beginning a downturn (later known as the California economic black hole of the 1990s), and I was sitting on what I believed to be the largest concentration of commercial real estate in the region or country for commercial banks with total assets greater than $1 billion. …

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