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Material differences.


The commercial real estate problems facing life insurance companies are real and likely to be around for some time. But press accounts lumping life carriers in the same real estate boat with banks and thrifts are misleading.

The well-recognized weakness in the real estate sector continues to broaden and intensify. To the extent the economy continues to stagnate and the real estate crisis deepens, companies with high real estate exposures--within the insurance industry--primarily life carriers--will be pressed more and more by delinquencies and foreclosures. Matters are likely to become worse before they get better.

The real estate crisis, however, is not confined to insurance. Thrifts and banks are suffering a good deal more. In fact, there are pertinent differences between the situations in the insurance industry, on the one hand, and the banking and thrift industries on the other; differences that should be recognized to see the insurance industry dilemma in perspective.

Still, given all the current facts and circumstances, the insurance industry situation is far from hopeless. What should be done? What steps can be taken to alleviate the problems? What damage control is required? Before laying out the solution, it's important to understand how today's difficulties developed.

How the crisis developed

In general, the current depressed condition of a major portion of the nation's real estate markets can be traced to recent factors. During the 1970s and early 1980s, syndication and speculative development grew rapidly. Partial deregulation of the thrift and banking industries in the early 1980s made funds readily available. Syndicators, speculators and developers were ready to borrow, while lending officers were eager to lend. The resulting overdevelopment was certainly not surprising. Moreover, the vast new inflows of foreign investment from Asia, Europe and even the Third World added more fuel to the development fires. During this same period, real estate prices were driven to new heights in many markets.

Finally, the industry suffered from an about-face in real estate tax policy. While earlier tax legislation (especially the 1981 Tax Act) had spurred development, the 1986 Tax Act took away many of the previously enacted tax benefits in a punitive way. By eliminating tax incentives, Congress changed the rules of real estate development so that prices--previously justified by tax incentives--fell.

Too much space

In many key markets, the industry built space that may take 10 to 20 years to absorb, assuming even the most modest ongoing construction. Even though demand has been strong in some markets, widespread overdevelopment in the early and mid-1980s has led directly to the depression of a significant portion of the nation's real estate market.

In reality, of course, a national real estate market is an abstraction. There is no such single market that can be said to be depressed or booming. Instead, there is a myriad of individual local markets--by some measures, upwards of 3,000 separate and distinct markets. While real estate is strong in some, this is clearly not the general condition across most of the nation.

The current excessive supply in real estate arose during a period when business activities were expanding rapidly, when businesses and individuals had the income and the need to occupy new space and when, in fact, space absorption continued to grow in most markets. Now, with a decrease in growth and a lessened demand for space, the economy will take longer to successfully work off the excess supply.

The recession continues

Unfortunately, the economy continues to be mired in a recession. Economists differ in their views on the severity and length of the recession, with a minority looking for one of unknown depth and duration. Obviously, crytall ballgazing is an uncertain game, but the question that begs to be answered is how much worse the downturn in real estate can become if the U.S. continues to experience hard economic times.

A long-lasting, deep recession would devastate the real estate industry. Vacancy rates are the clearest indication of the strength or weakness of real estate markets. Nationally, office vacancy rates peaked in late 1986 and early 1987. Although economic growth continued through 1988 and 1989, office vacancies stabilized at the abnormally high rate of 20 percent. And growth fell last year.

Given the recession, the prognosis for real estate is bleak. Vacancies in office and industrial space will undoubtedly rise. Although new construction has already been sharply curtailed, additional space will continue to be added to the supply. Ever more vacancies will increase competition among landlords for tenants and, as a consequence, will depress average rental rates further. At the same time, operating expenses will continue to increase, and not all such costs will be passed through to tenants.

In short, many landlords will experience higher vacancies, lower rental incomes and higher operating expenses. They will be less likely to be able to meet debt service on time, so delinquencies and foreclosures will increase.

Rise in delinquencies and foreclosures

Statistics assembled by the American Council of Life Insurance (ACLI) show that mortgage delinquencies and foreclosures in the life insurance industry peaked in 1987 after having more than tripled since 1980. The peak reflected loans on one-to four-family residences and agricultural loans. Since 1987, delinquencies and foreclosures in this category have declined significantly. On the other hand, delinquencies and foreclosures on commercial properties have steadily increased. Given the overlay of any recession, it is reasonable to expect that the rise in commercial delinquencies and foreclosures will continue, and probably accelerate.

Relevant differences in real estate situations

During the past year, the press and others have been prone to point out the similarities in what is termed the precarious financial health of the thrift, banking and insurance industries. But there is a reluctance to recognize relevant differences in the industries' situations.

The ACLI has given one of the clearest answers yet to those who have all three industries skating on the same financial thin ice. Responding to an inquiry from the Subcommittee on Oversight and Investigations of the House Energy and Commerce Committee, the ACLI, according to its news release, wrote to the committee's chairman, Rep. John D. Dingell (D-MI):

The financial situation of the

life insurance business contrasts

markedly with that of the thrift

industry. For example, during the

period from 1977 through 1987,

when the thrift industry's

capitalization was eroding, capital and

surplus of life insurance

companies more than doubled, with an

increase of $44 billion. Moreover,

life insurance company

profitability has been rising for two years.

The industry's net operating gain

increased 30 percent in 1989, the

same percentage increase as in

1988.... Obviously, all life

insurance companies are not the same

strength and financial condition.

And, as is true in all segments of

the business community, some

companies have taken more risks

than is wise. But there is no

emergency which broadly

threatens the promises the life

insurance business has made.

Of course, beyond these general observations concerning the health of the industry, there are evident differences among the real estate interests held by the thrift, banking and insurance industries. The real estate portfolions held by most insurance companies are simply more sound than those held by many institutions in the thrift and banking industries.

Less exposure for insurance companies

To begin with, regulation in virtually all states has limited the loan-to-value ratio for insurance lending to 75 percent. In the early and mid-1980s, the thrifts and banks often lent at substantially higher loan-to-value ratios. Thus, from the outset, their exposure was much higher.

Second, consider that the thrifts and banks provided the bulk of short-term construction and development financing used in the real estate industry. These short-term loans were predicated in most cases on the successful completion of projects, the developer's ability to lease up and stabilize the property and the availability of long-term financing that would take out the construction and development financing. As the real estate industry slipped into its current depression, these conditions were all too often impossible to meet.

Next, recall that the insurance companies have tended to require superior collateral. Most have preferred to lend over the long-term against investment grade properties--often stabilized trophy properties having intrinsic long-term worth. In contrast, the thrift and banking industries have more frequently lent against newly built, unoccupied or unstabilized properties. The established occupancy base of investment-grade properties directly translates into more stable cash flows and thus into reduced delinquency and foreclosure risk.

Finally, the thrift and banking institutions are highly localized in much of the United States. As a practical matter, the bulk of real estate loans held by these institutions tended to be less geographically diversified than the holdings within the insurance industry. In many cases, the diversification of insurance portfolios, by geography, type of property and maturity, is a clear source of strength.

Given these differences between the thrift and banking industries and the insurance industry, the urgency in addressing mortgage and real estate exposure may seem to diminish.

Active posture needed

Survival in today's real estate environment requires an active rather than a reactive posture. There is a natural tendency in every organization to carry on as usual until delinquencies and defaults rise. When they do, however, it is difficult and perhaps too late to change gears, to reallocate resources and to develop an infrastructure to monitor and manage situations from an economic rather than from a statutory or accounting perspective.

Real estate restructuring and workout is an inherently labor-intensive activity. A successful workout requires a significant multiple of the professional time that a client's staff would otherwise apply to a performing asset. As delinquency and foreclosure rates rise, the leverage is entirely against the creditor.

What happened to the thrifts and banks in the Southwest is similar to what happened to General Custer at the Little Big Horn. Custer was a fine cavalry officer and his troops as good as any in the U.S. Army. But with too few troops he ran into a much larger opposing force on the battlefield. The thrifts and banks developed too many nonperforming assets at a time when they lacked the capacity to deal with them.

How do you deal with the problems? Sitting on your hands and waiting for change is not going to make things better. In the present circumstances, pre-emptive action--that is, implementation of a pre-emptive strategy--is the key. Troubled real estate situations need to be addressed before they become delinquent or reach default. Pre-emptive action allows both the debtor and creditor maximum room to maneuver. In the long run, it also reduces costs and cuts losses that almost inevitably accompany a more adversarial workout.

From our experience in helping many clients deal with real estate restructuring for various reasons, there are six steps that should be taken.

Focus on the problem

Begin by focusing on the problem. Before doing anything, assess whether your company has a current or incipient mortgage and real estate problem and whether an in-depth examination is warranted.

Companies, of course, vary widely in their investment policies. Some life companies have minimized their investment in real estate and mortgages. Others appear to have done their analysis homework quite well and have relatively low delinquency and foreclosure rates. So an informal review conducted with minimal disturbance may meet your needs.

In making such a review, make benchmarks of mortgages and real estate in your portfolio. Compare the composition of your company's portfolio to the industry, noting, for example, any obvious concentrations in certain areas that could cause trouble. Be sure to question the senior investment professionals. And evaluate the general vulnerability of your company and the possible need for a contingency plan.

Assess the problem's magnitude

If a broader examination is necessary, assess the magnitude of the problem in considerable detail. Form a task force that includes investment, accounting, auditing, actuarial and systems professionals. Set a deadline for their report of not more than three or four weeks. You're really asking for a situation analysis that will form the basis for all of your subsequent planning, so ask the tough questions. Don't let your team off easily; your subsequent actions will be predicated on their findings and conclusions. Be sure that they look beyond simple compliance with the National Association of Insurance Commissioners Examiners Handbook and that they get down to assessing the practical economic and operational issues.

Be sure these questions are answered in your task force's evaluation.

* How large is our mortgage and real

estate exposure? How much is

hidden in mortgage-backed securities?

How much in joint ventures? How

large is our fiduciary responsibility

for assets managed for others? * What is the character of our

exposure? Are we diversified

geographically, by type of property, by

duration? Are there concentrations

that logically pose problems? * Are our basic policies, procedures

and practices sound and effective?

Are our files complete and current?

(Most are not complete and,

therefore, hamstring recovery efforts

when a crisis strikes.) Do we

monitor our exposure in an economic

sense or simply fulfill the

requirements of statutory or GAAP

accounting? Are our underwriting and

workout policies, practices and

procedures up to date? Are they

consistent with today's hostile

environment? Are they actually being

implemented? * Do we have the resources needed to

handle adversity if it arises? Do we

have enough of the right people?

(Lending officers often do not make

good workout specialists.) Are they

located where the action is and

where we think it might develop? * Are we already behind the "power

curve?" Do we wait until

delinquency and default before contacting

debtors? Are we rationing our time

and, therefore, starting to let the

"small ones" slip by? * What is our plan to meet a possible

rise in delinquencies and

foreclosures? What's right and what's

wrong with this plan? What should

we do now?

Tighten underwriting

No matter what else you do with respect to real estate, make sure that your company doesn't become a "home for the homeless" in a deteriorating market. Tighten loan origination. But keep in mind that those who take a contrary view of the current real estate market crisis may think there are tremendous opportunities about to surface.

Depending on your company's situation, tightening loan underwriting might mean limiting originations in areas where your exposure is already too high,

eliminating consideration of certain types of credits and raising the economic and credit hurdles. Do whatever is required to assure yourself that the loans added are not likely to pose a future problem and, in most instances, that they will strengthen the portfolio. Don't lend against anything that you would not want to own in a very soft market.

Coordinate workouts

Coordinate and manage current restructuring and workout situations effectively. Companies often organize their real estate staff along regional lines, and the responsibilities for restructuring and workout are similarly assigned. If your assignments are truly geographical, you can be almost certain that a portion of your real estate professionals are swamped by restructuring and workouts while others are bearing less than their fair share of the work.

You should manage both resources and problems as two businesses that complement each other. Rank your real estate professionals according to their abilities in restructuring and workouts. An effective real estate workout specialist should have strong real estate skills and be "street smart," with a personality that can alternate between sweetness and sternness. Not all lending officers can fill this bill. After all, they are responsible for attracting loan applicants and for developing long-term relationships with now-delinquent debtors whom they have often come to think of as personal clients.

View your professionals as falling into three classifications: those who can handle the most complex and adversarial restructuring and workouts; those who can administer only the moderately complex or less contested; and those who can support the others.

At the same time, also rank your restructuring and workout situations into three classifications: those that can be resolved so the debtor remains in possession; those where negotiations are likely to be heated but where the prognosis is that the debtor can work out the situation; and the most severe and adversarial situations, in which the debtors are most likely to retain "hired guns" to represent them.

Your strategy should in each case match your personnel's skills and abilities to the severity of the issues. And staffing should change if and when a situation deteriorates. A debtor has leverage and frequently raises the ante, so be sure that your offense matches the debtor's defense.

Coordinating workouts and restructurings should be viewed as the first order of damage control or management, an effort to bring order and direction to what is all too often an exercise in corporate firefighting. Pre-empting emerging situations extends this approach by attempting to identify and apply preventive action to latent situations before they deteriorate.

Pre-empt emerging situations

Establish an early detection and identification system that applies an orderly series of treatments in anticipation of delinquencies and default. The development of an early warning system, however, is a difficult and complex task in itself.

Between 70 and 80 percent of U.S. insurance companies fail to grade and monitor the economic performance of their mortgage and real estate holdings effectively. Companies often evaluate the quality of mortgages and real estate using statutory and accounting criteria. But this approach has several defects.

Using sophisticated analytical methods to look at the underlying economics is more effective.

An appropriate early warning system should model the facts and circumstances of each asset from the perspectives of the debtor, the creditor and the market in general. Such a system requires marshaling a great deal of current information. In one system built by Coopers & Lybrand for a major commercial bank, more than 60 data classes make up the supporting database. An additional database provides a library of information on several hundred individual markets. Specialized algorithms and utilities enhance the analytical capacity of these systems.

Early warning systems are tailor-made managerial and operational control systems. When implemented, they permit the early identification of likely delinquencies and defaults--and trigger prompt pre-emptive action. Pre-empting emerging situations is simply cost-effective. It reduces losses and retains long-standing clients who might otherwise be lost. Essentially, it is an "offensive defense." Treatments of situations become less severe and less adversarial, but they are nevertheless effective.

If the weakness in the real estate sector continues to broaden and intensify, the concerns expressed by those who advocate that the financial situations of the thrift, banking and insurance industries are parallel will intensify. Perceptions of Wall Street, the rating agencies and ordinary policyholders, whether or not they are justified, can hurt your company.

Communicate effectively

What should you do? Communicate effectively with a broad range of internal and external audiences as you develop and implement a comprehensive strategy for surviving in today's real estate environment. Specifically:

* Develop position papers describing

the facts. * Issue instructions on how they

should be presented by your

company's managers and employees. * Establish an appropriately unified

position describing the significance

to your company of the broadening

weakness in real estate. * Use targeted presentations to tell

the story to your board,

shareholders and/or policyholders, the rating

agencies and regulators. * Become an advocate for the

industry on this issue.

The situation is not hopeless. For most insurance companies, in fact, it is not even desperate--if problems are effectively and aggressively addressed. The greatest risk is to be complacent and overconfident. Complacency and overconfidence were the real mistakes underlying General Custer's tactics at Little Big Horn. Just don't allow the situation to surprise or overwhelm you.

John W. Frank is a certified management consultant (CMC) and a certified public accountant (CPA). David L. Millstein, a CPA, is chairman of Coopers & Lybrand's national real estate industry services group, and has nearly 20 years' experience with the firm.
COPYRIGHT 1991 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:how to manage real estate lending in the current economic crisis
Author:Frank, John W.; Millstein, David L.
Publication:Mortgage Banking
Date:Dec 1, 1991
Previous Article:Origination specialists.
Next Article:When fortunes fall flat.

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