By Jerry Rotunno
Senior Vice President – Associated Bank
Commercial banks have returned to the investment real estate market. However, much has changed since the market crisis of 2008. Banks have recognized the need for higher amounts of capital. There are new regulations with effects that are both known and unknown. The fundamentals of loan underwriting have changed to address current economic challenges.
Appraised value in a low transaction market remains the most difficult 
problem. There is still the risk of inflation and rising interest rates. All of these issues are new and can be managed. The environment is stable enough for the banks to increase lending on commercial real estate. Due to its relative stability and strong cash flow, industrial real estate remains a preferred property type and a better year is ahead in 2011.
The key lesson from the banking crisis is that banks need to be better capitalized, and thus better able to withstand shocks to the economy. How a bank recapitalizes depends on the options available to the bank. Associated Bank issued approximately $500 million stock in early 2010. With the new capital infusion, the bank was able to resolve its credit issues. Throughout 2010, Associated sold and resolved–through discounted resolutions–problem loans, totaling $597 million. As of December 31, Associated had a Tier 1 Capital ratio of 12.26 percent and at year-end, nonaccrual loans were down 47 percent from a year ago. Other banks have conducted public stock offerings or raised equity through private markets. Many banks are selling problem loans through discounted note sales or short sales to individual investors. Several banks that were unable to raise capital and deal with their problem loans have been merged into larger banks. This recapitalization process is not finished and will continue for quite some time. Many banks still need to raise capital and many more small banks will be merged into larger banks. As this process continues, a healthy and stable banking industry will emerge.
The government bail out of the financial business comes with a cost: new regulations. When the crisis hit, the regulators visited the banks with a mission to curtail aggressive lending policies. Aggressive is a subjective term and most banks chose to avoid the criticism and stopped lending completely. Then in July 2010, the federal government passed a 2,300 page financial overhaul bill. It is not clear if any one person read the entire bill. It was not posted on the internet for 72-hours as is often promised in election years. The truth is that we do not know how the bill will change the business. This law will create thousands of new pages of regulation and new agencies whose bureaucrats will determine how to interpret the law.
We do know that banks will continue to be heavily regulated and will conduct business with the next government audit in mind. The fear of a potential loan downgrade (and the requirement to allocate more capital to it) weighs heavily on the banking business. There are also many yet unknown consequences of this bill that will become apparent as the law is implemented. Bankers tend to fear the unknown and will react with more conservative underwriting. This means more equity will be required for investment real estate deals. Despite the need for higher levels of equity, there appears to be enough willing investors who see the return potential of buying in a down market. Very few deals have closed over the last few years and many investors are anxious to allocated capital.
The cautious approach to loan underwriting reflects more than the increased regulatory requirements. There is still some uncertainty in the local industrial market. We have seen many industrial users come back after near-death experiences in 2008. The days when tenants ask for temporary rent concessions are gone. Now we see tenants who used to operate only one shift expanding to two shifts, seven days per week. Banks have come back to lending to these tenants, who are cautiously investing in their businesses. Industrial production and capacity utilization have both been steadily increasing over the past few months. This trend is expected to grow in 2011.
Bankers are spending more time understanding the tenant’s business prospects. Prior to the economic downturn, a real estate banker could assume that most tenants were profitable. Today, more due diligence will be conducted. With a more stable tenant base, the property income is more predictable. Any loan completed today is based upon income in place. Properties without sufficient and stable income to cover debt service are difficult to finance. Speculating on future leasing is risky in a low transaction environment. The more stable and predictable the property’s income stream, the more financeable the property will be.
Appraised values remain the most difficult area of the lending process. Investors complain that the appraisers are too conservative. With the low level of transactions during the last few years, it is hard to estimate the price at which a property will trade. It is hoped that there will be more activity in 2011 that could create a more predictable appraisal process. Until then, bankers will underwrite conservatively and require loan-to-value ratios that are lower than in the past. For most lenders, today’s loan-to-value ratios are between 60 percent – 70 percent.
The effects of the financial crisis on the broader economy will continue to influence our local industrial real estate market. This is especially true with respect to interest rates. In 2008, the Federal Reserve Board reduced interest rates to record-low levels. In the process, it greatly increased the money supply in the economy. Nobel Prize economist Milton Friedman said that inflation is always a direct result of an increased money supply. As the economy improves, the Federal Reserve will eventually have to reduce the money supply or run the risk of inflation. In anticipation of this future constriction of the money supply, lenders are underwriting loans for the potential of higher interest rates. Today’s interest rates are between 4.00 percent and 5.00 percent but lenders assume that interest rates will eventually be 7.00 percent and 8.00 percent. This is another reason that loan-to-value ratios are more conservative than in previous years.
Commercial real estate departments within the banking industry face new regulations and economic challenges today. However, banks are managing these challenges and a have cautiously returned to lending on investment real estate. As the banks raise capital, it allows them to resolve their problem loan issues. A return must be paid on the new capital, so the focus is changing to new loan opportunities. An increased availability of financing will raise the number of transactions, thereby resulting in a more predictable appraisal process and a more stable investment real estate environment. All of these trends point to good news and better opportunities for those involved in industrial real estate in 2011.
