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Smaller Banks Still Facing Challenges

By Dr. Sam Chandan

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GlobeSt reported last week (see Paul Bubny’s September 1 article) that the rise in the commercial real estate default rate for bank-held mortgages slowed markedly in the second quarter. Based on an analysis of bank filings and FDIC reports by Real Capital Analytics, the default rate for multifamily mortgages - which up to now has exceeded the commercial default rate - actually fell over the same period, marking the first meaningful improvement in the metrics of distress so far this cycle.

While the second quarter’s update suggests that conditions may be easing, the improvement has been relatively isolated amongst larger institutions.

For banks with more than $10 billion in assets, the commercial default rate fell to 4.98 percent. The multifamily default rate declined, as well, to 4.21 percent. But at smaller institutions, default rates increased in the second quarter. At banks with $1 billion to $10 billion in assets, in particular, commercial default rates increased to 3.96 percent, up from a reported 3.57 percent last quarter. Multifamily default rates increased from 4.16 percent to 4.56 percent. Exacerbating the impact of higher default rates, the concentration of commercial and multifamily loans increased at these institutions, as well, from 33.2 percent of net loans and leases to 33.7 percent in the second quarter.

With smaller banks’ exposures located in more secondary and tertiary markets, the increasing default rate is part of a dynamic also characterized by a paucity of transaction activity and investor interest. As reported by Real Capital, an overwhelming majority of July’s transactions occurred in a select subset of primary markets, including New York, Washington, DC, Boston, Chicago, San Francisco and Los Angeles. Investors continue to avoid market risk by pursuing high-quality properties with strong occupancy and long-term leases in these markets, to the detriment of investment trends and mortgage performance outside of premiere locations.

Other findings from the analysis:

The default rate for commercial real estate mortgages held by the nation’s banks rose to 4.28 percent in the second quarter, up by just 9 basis points from 4.19 percent in the first quarter. The default rate in 2Q 2010 is 139 basis points higher than a year earlier. The delinquency rate fell from 1.44 percent to 1.14 percent between the first and second quarters.

The second quarter increase in the default rate is the smallest one-quarter rise since Q3 2007. In fact, the quarter-to-quarter increase in the default rate has been slowing since Q2 2009, when it jumped 64 basis points between the first and second quarter of last year. Still, the default rate for bank-held commercial mortgages remains at its highest level since 1992, when it was 4.55 percent.

The default rate for apartment mortgages held by the nation’s banks fell to 4.16 percent in the second quarter, down 47 basis points from 4.63 percent in the first quarter. Following the quarter-to-quarter decline, the default rate in the second quarter 2010 is 103 basis points higher than a year earlier.

The second quarter drop in the apartment default rate is the first meaningful decline this cycle and, apart from a marginal 3 basis point decline in 2007 Q3, the first decline of any magnitude since the real estate market peak. The improved apartment result coincides with early gains in apartment fundamentals. In its July report, Axiometrics reported that national apartment effective rent growth improved from 0.43 percent in June to 0.56 percent in July.  Annual effective rent growth improved from 1.12 percent in June to 1.80 percent in July.

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