The collapse of the residential real estate market and a wave of mortgage defaults took down several big local financial institutions. Now, there are fears that a second wave of defaults, these on commercial real estate loans, could claim its own victims.

Banks headquartered in Los Angeles County hold more than $28 billion in commercial real estate loans, which constitute more than 40 percent of all the loans currently on those institutions’ books, according to an analysis by the Business Journal.

At that rate, the exposure to commercial real estate among local banks is nearly three times the national average.

What’s more, a handful of large local banks, including Nara Bank and Center Bank, have more than 70 percent of their loan portfolios tied up in commercial real estate, placing them among the most heavily exposed large banks in the entire United States.

The two banks and others maintain that simply having a large commercial real estate portfolio does not mean they will incur substantial losses. They note that losses in their portfolios have so far been minimal.

Still, one analyst who reviewed the Business Journal’s analysis said he was unaware of the exposure facing L.A.’s largest banks.

“It was surprising, frankly, that there was such a significant concentration of banks with a heavy commercial real estate strategy. It is a bit of an eye-opener,” said Jason O’Donnell, a Boenning & Scattergood Inc. analyst. “It’s a fair assessment to say that those banks could be in greater jeopardy in the event that commercial real estate becomes a bigger problem in the third or fourth quarter of this year, which seems likely.”

Using data from the banks’ regulatory filings, the Business Journal analyzed the commercial real estate loan portfolios of all banks headquartered in Los Angeles County with assets of at least $100 million.

For the better part of the past decade, commercial real estate including office, retail, hotel and other commercial properties was booming across Los Angeles while property values skyrocketed. As a result, many banks became increasingly bold about their approach to the higher-risk loans and originated them in far greater numbers than ever before.

To date, L.A.’s commercial real estate loans have held up somewhat better than those across the rest of the country, given the relative continuing strength of some markets, such as medical office. Among local banks, borrowers are behind on just 1.7 percent of their commercial real estate loans, the Business Journal found, compared with a national rate of more than 2.1 percent.

Signs of stress, however, are becoming more visible across Los Angeles. Retailers are going out of business and hotels across town have seen business plummet. In the first quarter, the county’s office vacancy rate saw the largest quarterly increase in years, rising from 12.2 percent at the end of last year to nearly 14 percent. The industrial vacancy rate also rose a half-point to 2.7 percent.

Another big issue is that many real estate loans were issued over the last several years on property with inflated values. In recent months, L.A. buildings have sometimes resold at 30 percent discounts from a few years ago. Defaults on such properties often mean banks can’t recover their entire unpaid principal when the property is foreclosed on and sold.

“I expect there to be some real issues and real stress, and for the losses to be pretty meaningful to the banks,” said Aaron James Deer, an analyst with Sandler O’Neill & Partners who tracks several local banks. “It’s going to be an issue. How severe of an issue I don’t think we know yet.”

Already, the nationwide default rate on commercial real estate loans hit the highest level in 15 years in the first quarter, rising to 2.25 percent according to a report released this month by Real Estate Econometrics. The report projects the rate will not even peak until 2011.

“Typically, commercial real estate lags the economy by about two years,” said economist Sung Won Sohn, the former chief executive of Hanmi Financial Corp., the parent of L.A.’s sixth largest bank. “Commercial real estate probably still will have some difficult times to go through.”

Early warning

As early as 2004, regulators were warning banks about the potential for a severe downturn in the commercial real estate market. By late 2007, well before the term “stress test” had gained currency, the Federal Deposit Insurance Corp. was recommending that banks with large commercial real estate portfolios conduct such examinations to assess their relative risk should the market collapse.

“We’re always concerned where we see a lot of growth and a lot of competition, which drives margins down and where underwriting sometimes erodes. So yes, we got concerned about commercial real estate lending,” said Steve Fritts, associate director of the FDIC’s risk management policy and examination oversight branch.

Few banks, however, heeded the call and now many institutions, already grappling with losses on residential mortgage loans, have begun boosting their loan loss reserves in anticipation of losses on commercial real estate. L.A. banks upped their loan loss allowance in the first quarter nearly 10 percent on average, the Business Journal found, and many cited commercial real estate as a top concern.

The mounting losses have taken their toll on earnings and share prices. Local bank stocks tracked by the LABJ 200 index are off about one quarter so far this year, with some down more than twice that. Recently, several institutions have taken steps to mitigate the expected losses.

In early 2008, fearing the effects that a prolonged recession could have on commercial real estate, the management of Center Financial Corp., the L.A. parent of Center Bank, set out to reduce its nearly $1.3 billion exposure by at least $100 million. Though the secondary market for loans all but evaporated by late 2008, the bank still has managed to unload $91 million in commercial real estate loans and has scaled back its origination activity.

A bank spokeswoman said the steps have strengthened Center’s financial position.

“By setting into motion these sales early in the year, the company was able to conclude the transactions notwithstanding the widespread deterioration in the wholesale market in the second half of 2008,” said Angie Yang, a spokeswoman for the bank, which declined further comment.

Still, Joseph Gladue, an analyst with B. Riley & Co., said in a recent research report that “the company’s efforts have had limited success,” pointing to the fact that since its overall loan portfolio has shrunk, its percentage of commercial real estate loans has actually increased.

Commercial real estate loans now constitute more than 71 percent of Center’s total loans, giving it the sixth highest concentration among L.A. banks with at least $100 million in assets, and the second highest among banks with at least $500 million in assets. Indeed, Korean-American banks such as Nara Bank and Center, as a group, have among the highest exposure to commercial real estate. (Please see article, page 22.)

Like Center, Nara has, in consultation with regulators, opted to sell some of its commercial real estate loans a task that has become much more difficult of late. As an alternative, Nara is one of a growing number of banks attempting to modify loans and work with borrowers to ensure that they do not default. In some cases, that might mean allowing the borrower interest-only payments for several months, said Bonnie Lee, chief operating officer of parent Nara Bancorp Inc.

“As long as the borrower is willing to work it out, we try to work out the loan through modification or forbearance agreement, and give the customers time to survive this period,” said Lee, who added the bank is well positioned to absorb expected defaults. “Sometimes people make every effort to do it, but if the businesses are so down that no matter what they do they cannot cover the losses, there is nothing we can do.”

Deer, of Sandler O’Neill & Partners, said banks have considerable flexibility to work with their borrowers and will likely take pains to keep loans performing.

“The banks are probably going to be restructuring a lot of loans to work with their borrowers to see them through the downturn,” he said.

Conservative standards

Both Center and Nara, along with several other L.A. banks, tended to make commercial real estate loans that totaled no more than 60 percent to 70 percent of the underlying real estate’s value (the so-called loan-to-value ratio).

These relatively conservative underwriting standards could ultimately help the institutions weather a prolonged downturn even in the case of defaults, since a bank should be able to recover most if not all of its principal. Some banks have been even more conservative.

Farmers & Merchants Bank of Long Beach, for instance, tends not to surpass a 50 percent loan-to-value mark. So even though commercial real estate constitutes nearly 60 percent of Farmers & Merchants’ portfolio, the bank is not concerned.

“Our approach has always been 50 percent or less at the time we make the loan,” said Henry Walker, chief executive of Farmers & Merchants. “We don’t anticipate any problems with our portfolio, both because of our conservative lending practices as well as our conservative borrowers. The other lenders out there that lend at higher loan-to-values, candidly, will have problems.”

However, analysts stress that to get the full picture of a bank’s commercial real estate risk, it is important to look beyond the simple portfolio concentration. A range of factors, including underwriting standards, geographic concentration and industry exposure, can change the relative risk profile of an institution.

One important distinction analysts cite is the concentration of loans to owner-occupied versus nonowner-occupied properties. Owner-occupied properties, including small storefronts and individual warehouses, are those in which the borrower occupies at least 51 percent. These loans often function more like business loans and tend to hold up better in downturns.

Nonowner-occupied properties, on the other hand, rely on cash flow from tenants, who can come and go.

“Nonowner-occupied commercial real estate is really the hot button, because that’s the piece where we’re going to expect the greatest amount of credit losses in the back half of the year,” said Boenning & Scattergood analyst O’Donnell.

According to the Business Journal’s analysis, roughly two-thirds of local commercial real estate loans were made on nonowner-occupied properties a number O’Donnell said is “unusually high.” Banks typically have about half of their portfolio dedicated to nonowner-occupied, he said.

O’Donnell recently conducted his own analysis of publicly traded U.S. banks with at least $1 billion in assets and ranked them by exposure to nonowner-occupied and overall commercial real estate. On the aggregated list, the top four spots were occupied by local institutions: Nara, Center, Wilshire Bancorp Inc. and Hanmi. Another local institution, Cathay General Bancorp, also placed in the top 25.

On sidelines

Now, many observers are in a wait-and-see mode as the commercial real estate market shakes out.

A handful of new lenders has cropped up in the commercial real estate space, including private real estate finance companies such as Mesa West Capital LLC. And some institutions, including City National Corp.’s bank subsidiary, continue to originate commercial real estate loans, albeit with a more cautious approach. (See interview, page 28.)

But overall, as many banks retrench, loans for commercial real estate can be hard to come by these days, lamented Blake Mirkin, an executive vice president with CB Richard Ellis Group Inc.

“Funds really seem to be locked up still. It’s much more difficult to get loans than in previous years,” Mirkin said, adding that even the loans that are available tend to be on somewhat onerous terms. “People need to put much more equity down in the loan-to-value (and) the cash return is, frankly, unattractive.”

However, with the next couple of years expected to be a roller coaster for both lenders and borrowers alike, he is not surprised. A huge number of the loans, many of which were made on properties at overinflated values, are not expected to qualify for refinancing in these tightened credit markets.

“Many billions of dollars are coming due on buildings that were purchased in the last seven years where the value is not there to refinance,” he said. “There are a great many people that believe that’s going to happen.”

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