4th Down Conversions and Why Banks Should Reduce Real Estate Risk

Commercial Real Estate, Credit Risk Management, Hedging

Football coaches, like bankers, often ignore the data. Take 4th down conversions for example. We see this week after week where college and NFL coaches punt or kick a field goal where statistics indicate that  they should go for it. Look at the chart below and you can see that coaches normally don’t go for a 4th down conversion (by a factor of more than 5) unless they are put in a situation where they have to, usually in the 4th quarter. Statistically, that is odd. The odds of conversion are statistically the same in the 1st quarter as they are in the 4th quarter – about 63% overall. In fact, when considering  game outcomes, the data leans towards going for it more in the 1st quarter than the fourth, as that gives you time to adjust your game and manage risk. Scores resulting from 4th down conversions in the 1st quarter reduce the need  to go for it in the 4th quarter. Statistically, there are really only three factors that should drive a coach’s decision to convert on 4th down instead of getting rid of the ball and they are: distance for conversion, ball position on the field and defensive strength. What quarter you are in doesn’t statistically matter. As such, to increase your score, coaches should go for a 1st down more often earlier. If they did, they would not have to go for it so much in the 4th quarter and the distribution shown below would be more even.

Swaps Derivatives ARC

 

In banking, it is the same way and the classic example is commercial real estate underwriting. Lenders tend to make more loans when capitalization rates are low than when they are high. This is the exact opposite of what should occur, as expected loss rates increase significantly at the top of the cycles. Low cap rates mean that your cash flow relative to your property value is low, meaning that your risk buffer is lower. The more volatile the property’s earnings are the higher the cap rate needs to be to offset the risk.

 

We bring this up because alarm bells should be going off at many banks. Cap rates for some property types, most notably multifamily housing, have broken the important 5% level in many markets. New York, San Francisco, Los Angeles, Boston, Seattle, Portland and Miami are just some geographical areas where banks need to think twice about lending into a prevailing 4.5% cap rate.  This cap rate leaves little room for error when rates rise or new supply comes on the market.

 

Historically, capitalization rates have averaged approximately 7.6%. Specialty properties, hospitality and industrial tend to be higher in the 8% to 10% range. More trophy like properties have lower cap rates, while secondary and tertiary market properties have higher cap rates. Properties that are new and/or have longer lease terms tend to have lower cap rates, while riskier properties should have higher cap rates.

 

Remember also that cap rates and yield levels are correlated (reference graph below). Multifamily cap rates, for instance, shares about a 73% correlation to Moody’s AAA rated corporate bond yields, while office has about a 62% correlation. All else being equal (tax changes, more foreign investment, etc.), cap rates should increase about 50bp from mid-2015 to mid-2016 as general rates rise. Historically, a 0.25% change in capitalization rates moved property value by approximately 2.5% to 3.5%.  We may see a 5 to 10%l decrease in value just based on rate movement alone.  Add to that the extra supply in many markets and the fact that margins will be decreasing as bank’s floating rate loans will not immediately lift off their floors and you have all the makings of more risk and a lower return.

 

The time to go for more 4th down conversions is earlier in the game when the metrics warrant. If you are 4th and inches, you have almost an 80% probability of picking up the first down with a quarterback sneak play. In similar fashion, the time to expand real estate lending is earlier in the cycle when cap rates are high. With cap rates nearing record lows, and as we are nearing the 4th quarter of the real estate cycle, banks need to increase pricing and/or increase underwriting standards (increase debt service coverage, lower LTV and more covenants). If they do banks should see their winning percentage increase when it comes to real estate lending.

 

 

Cap rates and correlation to interest rates

 

Source:

Capitalization Rates from Real Capital Analytics

Chart: Texas A&M University Real Estate Center

Cap Rate/Property Sensitivity: S&P Global Property Evaluation Methodology