Banks' Bugbear: Commercial Real Estate

By PETER EAVIS A reason to love banks as investments also can be a reason to hate them. Because of the way they account for most loans, banks can absorb credit losses over time, allowing them to earn their way out of trouble. A potential downside of this approach: Banks use it to postpone the recognition of losses. And commercial real-estate lending is one area where losses are likely to be enormous. As a result, investors need to look out for potential danger signs flashing over bank exposure to commercial real estate. First steps include measuring commercial real estate as a percentage of tangible common equity and spotting large exposures to once-overheated markets. These might have already raised red flags about a bank like Synovus Financial, whose commercial real-estate exposures are a reason its stock hasn't participated in the bank-stock bounce since March. Of course, problems are rarely obvious. And the longer commercial real estate remains depressed, the greater the need to burrow into banks for signs that commercial real-estate losses could end up being larger than expected. First, look out for banks that have taken almost no hits to commercial real estate, especially if they are in stressed markets. Take City National, a Los Angeles bank with $17 billion in assets. Granted, its construction loans are showing considerable weakness. But the commercial real-estate book for finished buildings looks pristine. Since the start of 2007 that $2.17 billion portfolio has shown net charge-offs of only $838,000. And nonperforming loans of $16.9 million amount to a mere 0.8% of the total. In effect, that means that commercial real-estate book is held at about 99 cents on the dollar. Of course, City National may get through the storm with low losses. But the fact that it has taken such a small hit could mean that there is more pain ahead. The stock, trading at 1.4 times tangible book, could be vulnerable. Another tack is to try to get a closer read on the actual properties backing commercial real-estate loans, to see what banks might make back in the event of foreclosure. CVB Financial, a bank-holding company in Ontario, Calif., has high exposure to commercial real estate in the Inland Empire, one of the worst-hit markets in the U.S. One local borrower is a property-investment firm called the Garrett Group. It has borrowed about $85 million from CVB Financial's bank subsidiary, according to Garrett Chief Executive Kirk Wright. That is about 19% of CVB's tangible equity. Court documents give details of some of the commercial real-estate collateral Garrett has provided, and in some cases it is land, which in the Inland Empire can be worth little. Mr. Wright said the collateral is worth more than 100% of the loan. But he also said: "We have got such a fluid market. It could be 120%, 150% or 90%." He said the collateral also includes interests in limited liability corporations, but he declined to give more details. CVB Financial trades at a healthy 1.2 times tangible book. Commercial real estate can even be an issue for investors after underlying properties have been foreclosed on. Then, investors should gauge if banks are holding onto foreclosed assets for too long, exposing them to falling recovery values. BB&T's foreclosed assets, mostly real estate, totaled just over $1 billion in the first quarter, equivalent to 37% of nonperforming assets. That is more than double the 14% average for Regions Financial, SunTrust Banks and Synovus. And BB&T said the first-quarter increase in foreclosed assets was mainly due to soured commercial real-estate projects. As the commercial real-estate crackup continues, investors looking for value among America's regional banks need their wits about them. Write to Peter Eavis at peter.eavis@wsj.com