Creating Greater Lifetime Customer Value Through Loan Structuring

Increasing Lifetime Value in Lending

Customer lifetime value (CLV) is defined as the total profit generated from a customer over the entire life of that relationship.  In banking, CLV is a very important concept because of the high cost sourcing, underwriting and originating commercial loans.  On the first day a commercial loan is booked, the return on equity (ROE) on that loan is negative.  The bank’s profit is generated as the borrower pays interest over the life of the credit and, generally, the longer the period of the relationship, the higher the CLV for a commercial loan.  Nowhere is the CLV concept more stark than in construction lending. 

Not only are construction loans short-term facilities, but they have the added drag of having higher overhead costs, lower dollar outstanding (thus lower interest income) and much higher risk due to having credit, operating/completion risk and higher liquidity risk compared to a term loan. Below, is the profitability of a typical $1.5mm commercial construction loan.  As can be seen, despite strong margins and fees, profitability is low. However, there is a strategy that some community banks deploy to increase CLV on construction loans which turns a low ROE construction loan into a profitable credit and converts transaction banking into relationship banking.  

Construction Loan

Construction and Perm Single Close

Rather than close just the construction loan, many community banks are providing single close construction through perm, and establish the terms, structure and rate on the takeout facility at inception.  The closing requires one set of loan documents but typically two promissory notes (a construction note and a term takeout note).  At the start of the construction the borrower commits to a term facility to replace the fully disbursed construction note.

Value For The Borrower

There are a number of advantages to both borrower and lender to this single close construction through perm financing.  For the borrower the advantages are as follows: 

Certainty: The borrower’s interest rate risk is protected because the takeout facility rate is established at the inception of construction. In a rising rate environment, the ability to lock the interest rate for a forward starting term loan is very attractive and the current market cost of doing so is quite low.

Stability: The borrower is able to deal with their relationship bank for the entire life of the project, not just the initial one year construction term. 

Cost: The borrower pays just one set of closing costs and loan origination fees.

Value For The Bank

There are advantages to the community bank of this single close construction through perm structure.  The lender gains the following advantages:

Lower Credit Risk: Stabilizing the borrower’s debt service coverage (DSC) ratio on the term loan facility mitigates a substantial amount of credit risk to the bank.

Value: Offering this structure differentiates the community bank from many other lenders (especially insurance companies and credit unions) who do not often offer construction facilities.  This allows the bank to upcharge for the service.

Reduced Competition: The single close eliminates the need to compete for the term loan after construction is complete.  Many national banks will avoid the construction project but swoop in for the term loan.  Having the single close feature assures a much stickier relationship.

Profitability: The 5, 7 or 10-year term loan is the plum facility for the bank.  It has lower risk, lower overhead cost and substantially increases the CLV, turning a negative ROE construction loan into a positive total ROE relationship.

However, in order to correctly structure the single close construction-through-perm loan, community banks must embed an appropriate prepayment structure so that borrowers are not provided an option to shop the term loan after the construction is complete.

Case Study

We recently came across a construction-through-perm structure that did not increase the CLV for the lender.  The loan was structured as a $5mm, 12-month construction project with a 6-year takeout term loan.  The term loan was priced at 4.75% fixed.  Approximately 9 months into the construction loan, and nearing the completion of the project, the borrower was approached by an insurance company that offered a 10-year term loan at the equivalent of LIBOR plus 1.90% credit spread.  Based on the current index, that pricing is approximately 75bps lower than the bank’s takeout term loan.  Unfortunately, the bank’s term loan had no prepayment provision and the switching costs for the borrower, while substantial in dollar amounts (approximately $30k to $40k) are small when valued on basis points of the loan spread (about 10bps).  Net-net, the borrower would save 65bps ongoing spread in switching to the insurance company’s facility.

Here is what the profitability of this loan looks like if you calculate the profitability on just the construction portion of the loan:

Loan Profitability

However, the community bank fought back.  The insurance company’s proposal had some downside features as follows:

  1. The loan could only be paid down in whole, but not partially.
  2. The prepayment penalty was a very onerous make-whole provision.  Meaning that the prepayment penalty on day one was 14% of the loan amount ($700k). 
  3. The insurance company would not permit the flexibility available with the community bank.  The alternative that could be offered by the bank would allow full loan portability, additional money advances, assumability by a new borrower and other bank features not offered elsewhere. 
  4. The final loan rate with the insurance company would be locked at closing based on an index.  The closing would be months away and subject to appraisal and documentation.  Alternatively, the community bank is able to lock an amended term loan immediately since it already has the appraisal in hand, and the security interest in the collateral.
  5. The bank can close the loan with no additional closing costs.

The bank would have been better served by embedding the right prepayment structure in the takeout loan.  However, given the above advantageous the bank was still able to retain the client albeit by decreasing its interest margin. This loan still comes out to a respectable 15% ROE and can be seen below:

Loan Profitability

Conclusion

CLV is an important consideration especially in industries that have uneven revenue streams.  Commercial lending is a prime example where revenue is initially negative (given the outlay in sourcing, underwriting and originating a commercial credit) and revenue turns positive only with the passage of time.  Commercial loans by their nature are profitable for lenders only when they are sticky enough to generate long-term coupons.  This is the real reason that banks should seek relationship rather than transactional business.  Further, construction loans are prime examples of low CLV products, while construction-through perm structures allow banks to convert a transaction into a long-term relationship with much higher CLV.  Finally, the single close construction through perm loan must be carefully structured so that the borrower does not retain the expensive option of prepaying the term takeout loan, which can turn a relationship into a transaction.