Banks put loans on “Watch” in order to better monitor the changes with the borrower, tenant, and property. Whereas a “Special Mention” loan has a potential weakness that deserves management’s close attention, a “Watch” loan may be thought of as a pre-Special Mention and may just require management’s loose attention. While the “Special Mention” classification as a very clear regulatory definition, “Watch” can be more of an economic category. For us, “Watch” loans are those loans that have an increasing probability of default that likely require action or additional monitoring so as to prevent a formal classification of Special Mention. In this article, we look at statistically what that currently looks like in today’s commercial real estate (CRE) market and put some clear probabilities on loan types by year of origination to help highlight where bankers should be looking for problems.
Probability of Default Volatility and The Essence of Problems
For the sake of definition, we will define the “Watch” category as any loan that has a subjective or objective increase in the probability of default by more than two standard deviations. If you assume the standard deviation is about 0.12% for the average community bank CRE loan, then any time the one-year probability of default goes up by 0.24% then it hits the “Watch List” regardless of any positive delinquencies or payment performance. For example, when the price of oil took a plunge back in August of 2014, the probability of default increased on many types of loans just because of the industry and not because of problems with any individual borrower or set or property cash flows.
Since the probability of default is based on future cash flow expectations, these are forward-looking and the calculations below, taken from a sampling of over 1,000 loans from across the U.S. can be thought of the probability of any given loan going into a Special Mention category. While this data shows a slight increase in the probability of Special Mention, it is still low by historic standards and has only shown an increase this past quarter.
Thus, you can read the above data as your 2012 originated loans have the highest probability of going to Special Mention while your hospitality and multifamily credits are the loan types with the highest probability of issues.
At present, we believe this data around Watch loans lead a potential Special Mention categorization by about 14 months. Hopefully, this data will give you a jump and where problem loans could arise.
Behind The Numbers
2012 peaks in credit stress because credit stress usually peaks for a loan between years four and six. As can be seen above, a lender has good information the first year, and then earnings volatility takes over and risk increases in some borrowers. By around year five, usually, a combination of loan amortization and appreciation takes over and starts to reduce risk. This is why you want to avoid this range when you structure a maturity or rate reset. It is also why banks make most of their money during the back half of the loan past year seven. It is in this area of a loan’s life when the risk/reward ratio is the most advantageous for bankers.
Most of the stress that is currently in the market is a result of the energy industry hurting hotels, motels, and apartments in areas like North Dakota or Texas.
In similar fashion, problems with retail compose 4% of the problems as major tenants continue to go dark and dated locations struggle to attract quality tenants.
Outside of energy, borrower issues such as high expenses, declining revenues (not related to occupancy) or maintenance issues hurting cash flows are the second largest source of loan problems. If you take out those properties that are outside of the energy areas, remove those retail loans that are impacted by credit stress related to lower than expected occupancy (excluding energy and retail-related issues), and you will find that lease issues compose about 10% of current loan issues.
Putting This Into Action
As the data above indicates, with any downturn, protecting your hospitality and multifamily loans should usually be your priority as those two segments usually run into problems first. Further, paying attention to your 2012 vintage of origination will help you better focus on risky credits.
This way of looking at the market is a new view for us, and we are trying it out to see if the predictive data gives us greater insight into CRE loan performance. The above matrix should help better allocate risk resources and give you an earlier view into what loans could go bad in the future.
Submitted by Chris Nichols on April 25, 2017