In loan pricing and structuring, our loan trading and hedging desk often sees dozens of loans per day. We look at loans from banks all across the nation, including our own, and one area that could be improved is the quantification of lease risk in commercial real estate. Unfortunately, there is not an industry accepted methodology for quantifying the risk, but we would like to start to put forward a couple metrics.
Below is a chart of the average cumulative lease rollover percentage for “A” quality loans. These loans can be thought of as a quality benchmark and while it does not represent the average credit quality at community banks; it is what we would strive for. These non-owner occupied commercial real estate loans are investment properties from across the country, the cash flow of which is derived from one or more leases. To put this in perspective, these loans have an average spread of approximately 2.20% over Libor, have a weighted average debt service coverage ratio of 1.47x and a weighted average loan-to-value ratio of 66%. As a group, these loans have a weighted average 0.83% probability of default and a 32% loss given default. This comes out to an approximate 27 basis point expected loss. In other words, if you had an economic reserve methodology for your allowance for loan and leases this would be your reserve as this would be your most probable loss.
As can be seen, the average quality investment property has a nice even structure to lease expiration. Every year, about 7% of leases come due. In this manner, should a downturn occur or the property undergo some extraneous shock, only a small portion of the lease structure comes due at any one time. This gives lenders time to react and property managers time to mitigate some of the risk.
Conversely, it is very common to have a lease structure like the one below. Here, a majority of leases come due between years three and four. This does not necessarily mean that this loan is higher risk, as lease rollover is just one of many factors, but all things being equal, a high amount of short-term leases means potentially greater cash flow volatility, higher operating expenses and a higher potential of failure due to an extraneous shock.
How to Put This into Action
Banks must understand when above average lease rollover risk is present, and hopefully our baseline average gives you a fair idea. Diversification of lease terms is prized by professional investors, but often given little premium by banks. Once your bank identifies properties with weak lease structures then lenders should place more emphasis on mitigation and can employ such tactics as higher pricing, property level reserves, maintenance/refurbishment budget or increased marketing. We published an article on the topic last year when we gave banks some metrics, calculation methodology and other mitigating factors. This article can be found HERE.
Banks can also take advantage when bidding or managing credit portfolios, as it can look for opportunities in keeping or acquiring properties with better lease structures and selling or disposing of loans to properties with weak lease structures.
While lease rollover risk is just one of many factors, 2015 represents a year when the risk is near an all-time peak for community banks. By understanding how to identify and mitigate rollover risk, your bank will be in a better position to have a better long term return on equity.
Submitted by Chris Nichols on February 24, 2015