We recently received a call from a frustrated banker attempting to retain an existing borrower. By way of background, the borrower approached our banker 11 months ago asking for a construction through perm loan. The proceeds were used to construct an owner-occupied industrial and distribution center. Our customer bank structured a 12-month construction loan priced at Prime with a 4.50% floor, followed by a five-year takeout term loan priced at 4.50% fixed on a 25-year amortization.
With the certificate of occupancy expected to be issued within days, the borrower was provided with a term sheet from a large insurance company that contained what appeared to be aggressive pricing and terms on a 10-year term loan. The borrower turned around and asked our banker to provide a competing offer.
It is common for insurance companies to avoid construction lending and compete for the term loan. In this instance, the insurance company was in communication with the borrower from the beginning of the construction period. Just as the existing construction loan was nearing completion, the insurance company approached the borrower and offered a 10-year fixed rate option on a 20-year amortization, priced at LIBOR + 2.00%, which at the time was 4.20% fixed. The insurance company was not charging any loan origination fees, and the borrower understood that there would be no prepayment penalties on the loan.
We believe that banks should be offering single closings for construction through perm so that the scenario above can be avoided. By creating the right structure, pricing and prepayment provision our bank could have prevented the borrower from entertaining the competing offer.
When this banker called to explain the circumstances, we quickly jumped to our Loan Command pricing model and calculated the risk-adjusted return on the loan both for the bank’s structure and for the proposed insurance company’s offer. We also calculated the prepayment provision offered by the insurance company and created a marketing piece to differentiate the bank’s loan offering.
For this specific loan, our community bank could have retained the loan and enjoyed an 8.8% ROE loan rather than losing the takeout portion of the loan and recognizing a small ROE on the construction loan of only 3.4%.
The output from our loan pricing model is shown below and the numbers show why just doing the construction loan is not profitable:
- The loan balances are small (average outstanding of only $1.029mm) and the loan term is short;
- Consequently, the interest earned on the loan is small even though the yield is high;
- The cost of acquisition and maintenance on this loan makes expenses proportionately high; and
- The capital charges on the loan (1.55% ALLL) make this loan credit intensive.
The profit and loss statement of the loan breaks down as follows:
On the other hand, the loan that the insurance company offered was substantially superior for the lender. The output from our loan pricing model is shown below, and the numbers prove why this term loan is substantially more profitable than the construction loan:
- While the margin on the loan is smaller, the average balances and lifetime value of the relationship is substantially higher;
- The probability of default on this loan is also lower (at only 1.1% per annum), thus requiring less capital. While reserves are slightly higher for the term loan than the construction loan, the revenue on the term loan is more than 10X the revenue on the construction loan; and
- The total maintenance and acquisition costs are lower as a percentage of revenue earned by the lender.
Ultimately, our banker lost the loan to the insurance company because the borrower wanted the bank’s response the next day. It also came as no surprise to us that the borrower misunderstood the insurance company’s prepayment provision. While the borrower was adamant that no prepayment protection existed - that was not the case. In reviewing the insurance company’s term sheet, we pointed out that prepayment provision described was onerous (11% prepay cost to the borrower out of the gate), and the prepayment provision lasted for the life of the loan. At that point, the borrower was only fixated on the attractive loan interest rate.
Banks win a disproportionate percentage of construction loans, but the better credit and more profitable product for banks is the construction and the takeout facility through a single close. Banks that do not structure the single close construction through perm loan stand a high chance of losing the term takeout to a competing lender. It is easy to structure the correct pricing, terms and prepayment scenario at the inception of the construction, but if not properly done could subject the bank to an inferior ROE. We believe that every bank should be using a RAROC (risk-adjusted return on capital) model to help structure more profitable loan outcomes.
Submitted by Chris Nichols on July 18, 2017