All bankers agree that the more equity an owner has in a property or business, the better the credit. While statistically true, the real question is how much does equity matter? Or, a similar question, what is that equity worth? The answer is that it depends on how much you are talking about and what type of loan you are talking about. In the companion graph, we have charted the probability of default with the ownership equity percentage. The solid line in black represents all commercial bank loans, while the dashed line are just commercial real estate loans.
For example, in C&I lending, the amount of equity the owner has in the business matters less than the average loan at the bank and far less than real estate. For non-real estate commercial loans, the asset is viewed almost solely by a set of future cash flows. However, for real estate, equity matters.
The extent at which it matters varies. As seen by the graph, the more equity the owner has in a building the lower the default rate. While all that is straightforward, smart bankers will start to realize that the amount of equity in a transaction can be equated to price, debt service coverage or some other factor.
Let’s say you face the following choices for a $3mm, 10-year loan, 25-year amortization on an office building with a 75% loan-to-value at a 4.57% fixed rate. Now let’s say you use our ARC hedging program and will enjoy a Libor + 2.10% loan. Using the ARC program you just removed all interest rate risk so you are left with largely credit risk. Now, the borrower makes the following offer:
If you go 80% LTV, you can increase the price to 4.90% or the equivalent of Libor + 2.43%.
What do you do?
It turns out, it doesn’t matter, as you are indifferent. Both scenarios, the 75% and 80% LTV equate to about an 11% risk-adjusted ROE, or about your cost of capital. While the 80% LTV scenario increases risk, it does so by jumping up the probability of default by about 70bp which equates to 21bp more of expected loss. Since risk and pricing are related, by increasing the rate on the loan, bankers can compensate for the risk.
The same can be said for taking upfront fees, having a cash deposit as additional collateral or getting greater debt service coverage. In the scenario above, you would still be at a point of indifference if debt service was 0.08x higher as that would reduce the probability of default to offset the higher expected loss.
As can be seen in the attached chart, equity matters the most up to about 25% of the property and then the slope starts to flatten out. Once you get to about 60% equity, the slope flattens out again and equity impacts the probability of default even less.
Understanding this trade off as illustrated in the graph is helpful in working with borrowers to balance risk, pricing and equity. The more tools you have at your disposal, the higher probability that a transaction gets completed so that everyone is happy.
Submitted by Chris Nichols on July 23, 2014