Community bank audioconference covers all the bases of 2004

RMA Journal, The, April, 2004 by Kathleen M. Beans

Real estate portfolios are always on the minds of community bankers, but with some economists saying that today's commercial and residential values are the result of a price bubble, bankers are especially watchful. During a recent RMA audioconference, three senior community bank officers discussed the impact a real estate bubble would have on their portfolios as well as their concerns about the regulatory environment, competition, and vendor outsourcing.

Like most community banks, the panelists' institutions have sizable real estate portfolios consisting of both residential and commercial mortgages. Noting that real estate is a local commodity, Richard Harbaugh, president and CEO, Equitable Federal Savings Bank, said, "It's difficult to make national comparisons and identify trends; however, some data suggest we may be sitting on a bubble. Since 1996, the medium-priced home is up by 30%. When you look at 30% over the last seven years, it may not appear exceptionally high, but adjusted for inflation, this seven-year run-up in U.S. home prices is the largest real gain ever recorded.

"In Grand Island, Nebraska, we have seen a tremendous increase in first-time homebuyers, and we have noticed a tremendous increase in the median price of homes. Real estate is high on the regulators' radar screens, particularly in some pockets of the country, but current data tells us there is no significant deterioration in real estate portfolios. Yet, we would be well advised to pay attention to Mark Zandi and other economists who forecast a day of reckoning in real estate."

Lower interest rates contribute to inflation in real estate prices, said Leon Moyer, executive vice president and chief credit officer, Univest Corporation of Pennsylvania and Univest National Bank & Trust. "On the commercial real estate side, values are driven by higher appraised values based on historical trends. GDP growth last quarter was 8.3%. If that continues, we won't know whether we're in a real estate bubble for perhaps five to seven years. Time will tell."

Are We in a Real Estate Bubble?

"Yes, yes, yes, and yes," argued Jack Goldstein, president and CEO, NBRS Financial. "I lived through the Washington, D.C., market real estate bubble and this market looks exactly like it. People are leaving equities and investing in real estate. Real estate returns are greater than commodity returns, and better than gold and futures. That's a real concern.

"The worst thing in our market is that vacancy rates are doubling--another similarity to what happened in the Washington, D.C., market. When commercial vacancies double, demand is slowing. As interest rates move upward, our yield curve will be the indicator.

"If investors are using mezzanine financing and also investing in securitizations, they will start to leave the real estate market. Capital will dry up and loans won't be available to keep the real estate market growing. But what most convinces me that we're in a bubble is that two large real estate developers in our market told me that they believe we're in a bubble. That's why they're not buying anymore. When real estate developers stop buying because they believe we're in a bubble, we're there."

Loan Exceptions Increase in Competitive Environment

The panelists agreed that more exceptions are being made as institutions compete for few available deals. "Competition continues to get tougher, and we continue to make more exceptions," said Goldstein. "That trend is clearly indicated in RMA's study, Beating the Odds: Revisited. The percentage of exceptions has continued to creep upward since the first version of that study was completed in 1999. As more competitors enter our market, we've been forced to change the way we approve loans. Also, the staff is getting younger. We have more business development people who want exceptions to get the business and less credit people."

The impact of exceptions depends on the economy. "As they say, a good economy always repays bad loans," said Moyer. "Sometimes we don't even know we had them on the books. All banks are making exceptions because of the competitive nature of the business.

"We have a large C&I portfolio. When considering an exception to a policy or underwriting standard, we take into account the cash flow of the company. Cash flow is what pays back the obligations. You're also counting on the individual business owner or company management to repay the debt obligations. So, we consider exceptions on an individual basis as well as on an aggregate one. Because of our size, we're fortunate to have an internal loan review function that monitors exceptions as a percentage of our originations."

The Amazing Retail Portfolio

Consumer portfolios have been like the Energizer bunny, remaining robust in an otherwise lethargic economy. "We really are in an extraordinary consumer cycle," said Moyer, but he's concerned it may not last.

"Household income and purchases over the last couple of years were helped by tax cuts, zero-percent auto financing, mortgage refinancing, lower inflation, and rising home prices," said Moyer. "But what will happen to consumer spending when these supports disappear?"