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Warren Smith, chief financial officer of 1st American State Bank of Minnesota in Hancock, Minn., sounded exasperated as he rattled off a long list of loans for commercial real estate projects that threaten to sink his bank.
There was "Gold Mountain," a planned community of million-dollar homes just north of Phoenix that never got off the ground because it lacked a reliable water source; three condominium projects in and near Miami now in default; and a troubled condo and retail development, called "Founders Circle," in Apple Valley.
For tiny 1st American, a bank with about $18 million in assets four hours west of the Twin Cities, losses on these and about 20 other syndicated commercial real estate loans -- loans that are sliced up among multiple lenders -- have wiped out nearly all its capital. "We're trying everything imaginable to get out of these deals without taking a loss," said Smith, who joined the bank in November 2007 after many of the bank's loans had gone bad. "But increasingly, that's just not possible."
Nearly two years after the economic crisis began, losses on commercial real estate remain the biggest threat to the financial health of Minnesota's community banks. Projects that were launched during the final years of the real estate boom are now hobbled with huge amounts of unoccupied space. Developers and deal makers that took out loans to buy or build these properties are no longer able to service their debt payments.
From unfinished housing projects in the far northern suburbs to emptying office parks in Edina, developers are walking away from their debts -- forcing banks to take large write-downs. Last week, for instance, a commercial broker began marketing 186 acres of raw land in Ramsey, intended for 600 houses, that was taken over by a Wisconsin bank. And later this month, a 200,000-square-foot portion of the Twin Cities' first suburban office park -- Pentagon Park in Edina -- will be sold at a foreclosure auction after its owners defaulted this summer on an $18.5 million mortgage.
Experts predict that rising losses on commercial real estate projects could topple up to a dozen of Minnesota's community banks this year, on top of the six banks that failed last year. The Minnesota Department of Commerce, which regulates banks and credit unions in Minnesota, estimates that its "watch list" of banks that are at greater risk of failure has reached 90 institutions, up from 50 a year ago and a mere 26 in June 2007.
"The banking industry, in general, has been waiting for commercial real estate to be the next shoe to drop," said Dennie Emmans, executive director of the Bank Holding Company Association, a trade association of about 250 bank holding companies in the Upper Midwest. "Well, now the shoe is dropping, and it's dropping pretty hard."
The delinquency rate on commercial real estate loans made by Minnesota banks has nearly doubled over the past two years. As of the third quarter, 6.3 percent of these loans were more than 30 days past due, up from 3.1 percent two years ago, according to Foresight Analytics, a California research firm.
Unlike the plunge in housing prices, which rippled through the financial sector immediately, the crisis in commercial real estate has taken longer to unfold. One reason, say experts, is that banks have built-in mechanisms in their lending agreements with developers that give them more flexibility in case of default. Many banks require borrowers to dip into reserve accounts when they fall behind on payments.
But if high vacancies persist for more than a year, as they have in the Twin Cities, the cash ultimately runs out. Landlords are often unable to afford both the debt payment and the cost of taxes, insurance and upkeep on vacant properties. Banks then have to order new appraisals, and add more to their reserves if the property has declined in value.
As a result of this long process, it can take a year or longer for a bad loan to actually appear as a loss on a bank's balance sheet, said Robert Viering, a bank consultant from Monticello. "Bankers, for the most part, are an optimistic bunch, and they're going to wait until they're absolutely certain that loan won't perform until they write it down," he said.
The woes in the commercial real estate sector are showing no signs of abating, and all sectors -- office, retail and industrial -- are struggling. Yet, bankers say they have been hit particularly hard by rising vacancy rates in strip centers. The retail vacancy rate for the metro area hit 10.1 percent last year -- the highest level since NorthMarq, a commercial real estate company based in Bloomington, began tracking the data more than a decade ago.
Many banks, fearing a surge in defaults, have taken a proactive approach, and have been scrubbing their loan portfolios of delinquent loans before the losses become more severe.
Dan Klein, chairman of KleinBank in Chaska, said his bank conducted a "top-to-bottom" review of its loan portfolio, reviewing every loan over a certain dollar amount. In some cases where a borrower may have been "underwater" -- that is, the property was worth less than the loan amount -- the bank set aside additional money to cover potential losses. The result was that KleinBank ended the year with a small loss, but the bank will be better insulated against future losses, Klein said.
As for Smith, the CFO at 1st American in Hancock, the struggle to recover money from failed commercial real estate projects has become a full-time job. Smith said he spends "100 percent" of his time trying to sort out loans that have gone bad, leaving him no time for developing new business.
"I've got so much going on that it's hard to keep track," he said. "It's just a matter of coming to work and hoping that I can get through it."
Chris Serres • 612-673-4308