Coming clean

US banks are currently sitting on billions of dollars worth of souring real estate loans. What for? According to Sam Zell, to stay alive banks and other real estate owners needs to come clean about their problems. By Zoe Hughes.

During the RTC crisis there was one phrase that summed up what real estate managers had to do to stay hopeful: “Stay alive ‘til ’95.”

Coined by Sam Zell, it became the mantra of a generation of fund managers not only affected by the savings and loan crisis, but also by those able to take advantage of it. This week, the chairman of Equity Group Investments came up with a new saying for the current real estate recession: “Got to come clean by 2013”.

His phrase highlights one of the major challenges facing the US real estate industry – the souring balance sheets of thousands of small community and regional banks scattered across the country’s 50 states.

Prolific lenders during the height of the boom, many of these banks originated massive amounts of commercial and residential real estate loans well in excess of their own equity assets. Delegates at this week’s annual Association of Foreign Investors in Real Estate (AFIRE) conference, heard that of the 7,830 banks insured by the US banking regulator, the Federal Deposit Insurance Corporation, 4,200 had an average exposure to real estate of 345 percent of their banking equity.

The FDIC has closed or resolved 118 banks in the year to 20 August. That number comes on top of the 140 banks that were resolved in 2009. However, the corporation’s list of troubled banks, those institutions it deems most likely to fail next, rose to 829 during the second quarter, its highest level since 1993.

Speakers at AFIRE admitted that dealing with the assets of banks “not in receivership” was one of the “top five” priorities facing not just the real estate industry and the FDIC, but the country’s economy. As some commentators have said, commercial real estate is the next shoe to drop.

However, as Zell explained at AFIRE, the shoe is unlikely to drop at all – and certainly not in the manner desired by private equity real estate managers. Speaking to AFIRE in his home town of Chicago, he argued that predictions of the “demise” of the industry had been “greatly exaggerated”, owing to banks’ willingness to extend maturing real estate loans, rather than writing them down to their market valuations.

Extend and pretend, as the practice has been dubbed, has been widely criticised by masses of property professionals, not just Zell.

But with no pressure from regulators to force banks to mark to market, extend and pretend is set to continue resulting in the slow delivery of troubled loans to market, and a slower repricing of assets.

As the 22nd annual AFIRE gathering heard from numerous speakers, though, the problem with this workout tactic lies not just in its consequences today, but in three years time when more than $1.5 trillion of commercial real estate mortgages and CMBS loans issued at the peak of the market are set to mature.

If banks are unwilling, or unable, to deal with many of today’s troubled loans, what is in store for them tomorrow? When the loans of 2006 and 2007 are maturing in 2011 and 2012, will banks even have the capability to deal with them, or will the problem simply pass to the FDIC and by default the US taxpayer?

Coming clean by 2013 will mean a chance at new health on the parts of banks and probably a major source of deals on the parts of real estate investors.