Why Haven’t There Been More Construction Loan Defaults?

Delinquency rates for CRE construction loans are “only” 12%; why is that?

Distressed Volatility quotes testimony from Richard Parkus - Head of CMBS and ABS Synthetics Research, Deutsche Bank (italics mine):

90+ day delinquency rates are currently in the 12% range for construction loans in bank portfolios, but are somewhat higher for construction loans in regional bank portfolios. In fact, I am perplexed by the fact that construction loan delinquency rates are only 12% at this point. However, I believe that this can be explained by the fact that they are typically structured with interest reserves which are sufficient to cover interest payments until the expected completion of the project. Thus, construction loan delinquency rates are currently artificially low due to interest reserves, but will likely rise dramatically within the coming 6-12 months. In my view, losses on construction loans are likely to be in excess of 25%, possibly well in excess, which would imply losses of at least $140 billion. This, of course, would be disproportionately borne by regional and local banks."

I agree with Parkus that interest reserves are responsible for keeping these loans afloat. Most construction loans are indexed to LIBOR, or less commonly, Prime. This chart from FedPrimeRate.com shows what has happened to these rates:

Construction loans started in 2005 or earlier were mostly refinanced before CRE permanent lenders pulled back, and CRE construction lending declined dramatically during 2008. As a result, the construction loans still out there were originated most during 2006 through the first half of 2008 (the period inside the ellipse on the chart above). The interest reserves on these deals were sized assuming prime would remain around 8%, and LIBOR would be at around 5%. Since then, prime has dropped to 3.25% and 1 month LIBOR is 0.29%. As a result, an interest reserve sized to carry a loan for two years can now cover interest costs for four years or more. So, even though projects are not hitting the occupancy and rent levels projected, many lenders are willing to extend these loans because the interest can be kept current from the original interest reserve without increasing the loan commitment. The hope is markets will recover before the reserve runs out or interest rates go up.

Getting Tilled: How a $6,425 Truck Loan May Decide the Fate of General Growth Properties

General Growth Properties, the bankrupt mall owner, has $27,700,000,000 in debt outstanding. The fate of the company will depend on the restructured terms of that debt. Those terms will probably be set according to a Supreme Court precedent which restructured a subprime truck loan.

Lee Till filed Chapter 13 bankruptcy and attempted to get the interest rate reduced on the loan secured by his 1991 truck. SCS, the lender, thought the rate should be 21%, because that was the going rate for loans to subprime borrowers secured by old trucks. The Supreme Court thought differently, and ruled the rate should be the Prime interest rate + 1.5%. The essence of the Court’s ruling is that in bankruptcy you start with Prime as a base rate and add a risk premium of 1-3%. You can find a summary of the case (Till, Lee, et ux. v. SCS Credit Corp., 2004) here and the syllabus which goes into more detail here.

If you’re a CRE lender, you might think that this doesn’t have anything to do with you. I know I felt that way, the first time I ran into Till a few months after the court ruled. How could the $12M fixed rate Fannie Fannie loan we serviced be repriced at Prime+1%? What about our yield maintenance provision? Why use Prime as a base rate? How could a large loan secured by a nice apartment project end up priced like a $6K loan on a 13 year old truck? When the borrower’s plan was confirmed, it seemed like a bad dream.

What’s even more surreal is this precedent will probably be used as the basis to reprice at least some of GGP’s $27B in debt. That’s what Bill Ackman of Pershing Square Capital Management is betting with his 7.5% stake in GGP’s outstanding common stock. Valueplays has a link to Pershing’s analysis of GGP’s value here. The discussion of the Till precedent starts on page 41. The bottom line is Ackman believes both that GGP’s debt will be extended, and the overall interest rate on their debt will be reduced.

Prime today is 3.25%, so a borrower in bankruptcy has a realistic shot at getting his loan restructured at a rate below 5%. That rate will allow a lot of partially leased income properties limp along. The risk of getting stuck with a low interest rate restructured loan is also keeping a lot of note buyers on the sidelines.

CRE Construction Loan Rates Today

The Wall Street Journal has a story here (hat tip Deal Junkie) about a $215M construction loan Boston Properties obtained on a mixed use project in Boston.

As you would expect, the terms are much tougher in many respects than were available a few years ago. The loan is for only 40% of the cost of the project (compared to loan-to-cost ratios of up to 90% during the boom days), and there are recourse provisions to the borrower (these provisions were often waived in the past).

But then there’s the interest rate:

The five-year loan carries a floating interest rate equal to the London interbank offered rate plus 3% annually. Two years ago, rates on similar loans were lower, said Mr. LaBelle [Chief Financial Officer at Boston Properties].

I suspect the reporter got that wrong; I suspect Mr. LaBelle said two years ago the spreads on similar loans were lower. The spread on this deal is 3%, and the spreads a few years ago were 1-2%. But, two years ago 30 day LIBOR was 5.320%, so the all in rate was 6.32-7.32%; Today LIBOR is 0.435%, so with Mr. LaBelle’s loan spread of 3% the all in rate is 3.435%, which is around half what the rate was two years ago.

If you told someone two years ago that you would be able to get a construction loan for a CRE project at less than 3.5%, they would have thought you were crazy.

Economy and Real Estate Post Picks: Week of April 20, 2009

Will the Recession End in a Few Months? Two economic forecasters think so

Can the Economy Function Without Securitization? This post argues restoring  securitization markets should be a top priority.

Commercial Real Estate Values at 2005 Levels: Moody’s Commercial Real Estate Indices indicate gains over the last four years have been reversed.

Which Way Are 10 Year Treasury Rates Headed? Two opposing views

What Will be the Shape of this Recession? V, L, or D?

This Time is Very Different: Attack of the Zombie Properties

The last time we had a severe CRE downturn was 1990 – 1995. For those of us who were around, the current situation feels similar – plummeting employment, deteriorating income fundamentals, spiking cap rates, and loss of liquidity in the market. However, there are some huge differences this time which have important implications.

First, some history. Here is a chart of cap rates taken from a paper by Philip Conner and Youguo Liang (Income and Cap Rate Effects on Property Appreciation, worth checking out):

Current value cap rates bottomed at around 6.7% in 1990, were around 8.25% in 1992, and peaked at around 9.5% in 1995. Based on the sales and appraisals I’m seeing and talk with colleagues, current cap rates seem to be in the 8% to 8.5% range, so today is somewhere around 1992 levels.

Now, let’s consider interest rates. A typical variable rate CRE deal in 1990 used an 11th District Cost of Funds index (COFI) plus 2.25%. An equivalent CRE deal in 2007 would have been priced at 30 day LIBOR + 2%. Here is how the interest rate would have changed on those two deals over the last 2 years:

Interest rates this time are much lower. In 1992, the cap rates were right around the interest rate, which meant a property with no equity also probably couldn’t make it’s payment. Today is much different; cap rates are 5.5% to 6% higher than the interest rate. This means a property could be severely under water and still make it’s payment. Here’s an example:

In an ordinary world, a property overleveraged to this extent would be foreclosed on and sold, but because interest rates are so low it can continue to make its payments.

What are the implications?

• CRE loans are collateral based, so under FAS 114 the bank probably needs to recognize the loss even though the loan payments are current. If the loan term is long enough, it’s possible the bank can make an argument the value will recover, and avoid recognizing the loss. But regulators and accountants these days tend to be pessimistic in their outlook, so the bank is probably stuck with recognizing the loss.
• If a bank attempts to foreclose on a basis other than a payment default (for example, loan maturity or a non-monetary covenant violation), the borrower will probably file bankruptcy. It is very difficult to obtain relief from stay and foreclose on a borrower willing to make their contractual interest payments (more on that here). So, the bank is probably stuck with the deal until interest rates go up and there is a payment default, unless they sell the note.
• If the bank sells the note for the collateral value, the return to the note purchaser is equal to the cap rate (in the example above, 8.25%). Note buyers are looking for returns in the 20% range, so these deals won’t appeal to them either.

I believe the result is we will have a lot of zombie loans on bank books, and a lot of zombie properties that are grossly overleveraged, but which can’t be cleared to market values because the borrowers can make the payments at today’s incredibly low rates.

Economic and Real Estate Post Picks: Week of February 2, 2009

Sharp Contraction in Trade: Both imports and exports have gone off  a cliff

Jobs Forecast by State and Sector: Interactive map and charts of a Moody's Economy.com forecast of job loss/gain by sector and state through 2012

The Housing Market: 1982 versus 2009: A comparison of our current situation with the situation in 1982

The Behavior of LIBOR in This Economic Crisis: Very detailed discussion of LIBOR and its recent movements

Upcoming Economic Indicator Releases: A useful calendar of upcoming economic indicator releases, with links directly to the data sites.

Low Interest Rates Will Not Spur New Waves of Defaults

Mr. Mortgage’s post Low Interest Rates To Spur New Waves of Defaults is being widely cited (see Infectious Greed, The Big Picture, Option ARMageddon, and Naked Capitalism). Possibly this story is attractive because it’s counterintuitive, and counterintuitive is interesting. In this case, though, I think it’s wrong.

The claim is counterintuitive because lower interest rates lower the risk of default. Lowering the amount of interest a homeowner pays reduces their debt burden, and that lowers the risk of a future default. There’s nothing in the post to indicate there’s any disagreement on that point.

The argument in the post has three steps:

1) The news of lower interest rates is stimulating borrowers to apply for lower rate loans

2) The applicants are being turned down because their homes lack equity and/or the borrowers credit scores have declined, and

3) The realization they lack adequate equity and credit scores will spur the applicants to default on their existing loans.

The basic argument is that borrowers are ignorant of their situation, and once it’s revealed to them a significant number will default. My first objection is admittedly a philosophical one – I am highly suspicious of arguments which depend on people’s ignorance, and especially so when every homeowner I’ve met in the last year is acutely aware of what’s going on. I’m the first to admit there are whole sets of cognitive biases which predispose people to overvalue what they own (endowment effect, post-purchase rationalization), continue to do what they've done in the past (status quo bias, sunk cost effects, loss aversion), and expect a positive outcome to their choices (optimism bias, and valence effects). Given these biases, borrowers may wrongly expect their homes would qualify for refinancing, and getting turned down will be disappointing. But, I don’t think there are very many applicants who would be surprised.

My second objection is there is no evidence to support the claim is occurring – it’s a plausible narrative, but without any support. Here’s the only portion of the post which attempts to quantify the problem:

From early reports since rates fell sharply in early December, 80% of the loan applications are not getting out of the starting gate easily. Loan officers are all saying the same thing — that appraisals are not coming at value due because ‘all of the foreclosures and REO sales have taken the value down’. In the majority of these cases, this kills the loan.

This is obviously anecdotal (I don’t think “out of the starting gate easily” is a metric anybody tracks). We don’t know the normal fallout rate either, but I’m sure these days it’s substantial. I’m sure lower rates prompted some applicants who can’t qualify under today’s underwriting parameters to come out of the woordwork, but I’m equally sure lower rates have resulted in approvals for some applicants who wouldn’t have qualified at higher rates. Without data there is no way to know the net effect, and to forecast "a “wave” of defaults seems a stretch.

My biggest objection to the claim is that it presumes new knowledge they lack equity will cause borrowers to default. Borrowers default because they can’t make their payments (usually as a result of income curtailment). There is no credible evidence lack of equity in and of itself results in defaults.

The argument also ignores the fact that borrowers who lack equity may consider continuing to pay their best option. If they default, they will still need housing, and with no equity from their current home that means the down payment will have to come out of savings. How many homeowners can do that? Alternatively, they could rent, but how many homeowners who can afford their current payments would make that choice?

The only group of borrowers I see who might default as a result of lower rates are those who have substantial liquid assets and can afford a new down payment but hadn’t previously thought about walking away (small group), or who are willing to join the renter class despite the fact they can make their current payments (also a small group).

I don’t see a wave of defaults developing out of lower interest rates.

Will Lower Interest Rates Help Home Prices?

I agree with CR about 90% of the time, but I think he’s off on his post yesterday about House Prices and Interest Rates. His argument is a plan to push home prices up by offering lower rates won’t help much because a rational buyer will realize artificially low rates now will not result in a higher resale value down the road. There might be some buyers who think like that, but I don’t know any. Many people prefer to buy if they can afford it, and interest rates are a key component of that equation. I’ve worked through the math in previous posts here and here.

Effect of Interest Rate Changes on Home Values

In a previous post I wrote about how aggressive underwriting (underwriting allowing a high percentage of income to be used for the debt, qualifying on low teaser rates and/or an interest only basis, low down payment requirements) can inflate home values. An even more basic rule is that a decline in interest rates increases values, and increases in interest rates reduce values. For example, the decline in interest rates between January, 1995 (when Freddie Mac's Primary Mortgage Markey Survey 30 Year Fixed Rate was reported at 9.15%) and January, 1999 (when the rate was 6.79%) accounts for almost all the increase in OFHEO's Housing Price Index during this period. Here's the math:

Of course, there are factors other than interest rates which also affect values (to be addressed in other posts). For now, my point is when other factors are in balance declining interest rates increase values, and rising interest rates decrease values.