A Commercial Loan Metric That Will Help Your Bank See The Future

Commercial Lending Risk Management

If you listen to the news pundits, there is lots of talk about asset bubbles. To figure out if banks are lending into inflated asset prices we turn to the data for answers. Since valuation is a function of future cash flow, having a more accurate vision of the future is helpful when lending. Once predictive factor to alert commercial real estate lenders is when supply outstrips demand by more than a 2-to-1 ratio. When this occurs there is better than a 60% chance that cash flow remains flat or even goes down, thereby hurting property values. A review of major markets in commercial real estate shows that supply and demand are moving in lock step and there is not reason to believe prices are inflated given the future cash flow. However, there is one market that is nearing that 2-to-1 ratio that merits additional risk management. To get educated on this metric that you might not be tracking, read on.

 

Yesterday’s FOMC meeting where the Fed highlighted low expectations of inflation, combined with a very strong GDP preliminary report of 3.94% and asset prices almost back to record highs, equates to one of the best times to be exposed to credit risk. In most all areas of bank lending, forward probabilities of defaults and loss given defaults are favorable for banking over the next two years (as far as we can see accurately ahead). As we look ahead to supply and demand trends, almost all subsectors of commercial lending look favorable and pricing looks to get even more competitive than it is already. The sole exception is multifamily housing. This subsector has not only had tremendous, 11% appreciation in asset prices year-over-year, but the run up in prices has caused a burst of construction.

 

While construction has picked up in most subsectors, it is only multifamily where supply outstrips demand by almost 2x. This week, we have toured five of the ten markets that are experiencing very strong loan growth to see the state of the market. We toured Austin, San Jose, Dallas, Houston and Denver in the past week. In all these markets, there was infrastructure and private construction sufficient to warrant concern. We looked at data from Moody’s, economy.com, American Community Survey, Axiometrics and the US Census Bureau to get to the latest data and then compiled it into a model that helps us project prices based on supply and demand.

The methodology for any commercial project is the same. Lenders, like government forecasters, use a common calculation to look at the future of rents, and hence cash flows.  For multifamily, for instance, pull the permits issued by the county and then assume that starts (permits that then move to construction) are 22.5% lower. Then assume the completions are 7.5% lower than starts. If you adjust for those units that are converted to condos or to single family construction (less than 5 units), the rule of thumb becomes about 73% of authorized permits are completed and become available to the market. The calculation methodology isn’t that much different for office, retail or industrial as well. Take the projected units and then compare to population growth.

 

For multifamily, here is what we found:

 

Austin is the classic example. There are 185k multifamily units available and over the last four years, they have added 37,759 more, or almost 18% of total supply - the fastest growing number of units of any major metro market. Population growth was 9% over that time, so demand outstrips supply by double. While occupancy is at 95% and rents are up 6%, that is likely to change as more and more supply comes on line. As such, our model predicts rents should remain flat and has a 30% chance of dropping 3% or greater between now and 2016.

 

While places like Austin, San Jose and Charlotte present potential danger due to high growth, but even higher supply, there is also the low growth areas that present heighten risk. Areas like Pittsburg and Providence, represent scenarios where multifamily construction growth is reasonable (0.8%), but population growth is next to flat (0.2%) indicating either lower rent or lower occupancy (or both) in the future.

 

While the supply/population ratio is just one metric to use when evaluating the future cash flows of commercial property, it is an effective one and has proven at least directionally accurate. Before you agree to that Libor + 1.6% multifamily loan pricing, make sure you are not lending into a potential bubble.

 

Commercial Lending Risk Management