It is a long held precept in banking that when lending on a commercial property, the majority of lease terms should extend past a loan’s maturity. For example, if most of the leases are three years in term, then a bank will often only want to make a three-year loan with the belief that the contractual string of lease cash flows will mitigate credit risk. Not only may this logic be flawed and have no basis in empirical evidence, but creating a shorter loan term to match the leases may actually increase the risk of the loan.
Banks, of course, want to strive to lend on commercial property cash flows that are as stable as possible. All things being equal, credit risk is increased by having short leases as opposed to longer term leases due to the greater probability of vacancy and the greater transaction costs associated with a revolving door of tenants. However, credit risk associated with tenant turnover is just one of many factors and turns out not to be dominant when assessing the probability of default and severity of loss.
We looked at more than 500 commercial property loans and regressed the average lease term at origination with approximately 26 loan defaults from the 2007 recession. What we found is that there was less than a 5% correlation (0.044). That is to say that statistically the length of lease at underwriting has almost no explanatory power to defaults rates.
To take our example above, the bank that reduced their maturity to match the average lease term did themselves no favors. If those leases were not renewed, the bank faces the same uncertainty and potential volatility of cash flows if the average lease term was two years or five years.
Tenant Risk In Perspective
Keep in mind that credit risk from lease rollover is just one of many risks and statistically fairly insignificant. To the extent your leases extend to the point of significantly helping to amortize the loan or extends well past the balloon maturity of the loan, then lease term has a significant impact on both credit and liquidity risk. However, this is rarely the case for community bank credit.
The greater risk in our example above is the risk of refinancing. By shortening the loan term the bank failed to improve the credit risk profile, but exacerbated refinance risk because as cash flow on that property improves, the bank is more likely to lose the loan to another banks. The risk of refinancing can increase substantially. While refinance risk is nothing that credit officers should be concerned with, it is a real economic cost to the bank with shareholder value impact that senior management must address and mitigate. In the example above, while the bank was seeking to mitigate lease risk, it is the refinancing risk that is more material.
Your Credit Team Bias
The problem of placing too much reliance in average lease term is usually exacerbated by the underwriting team’s perspective. Community bank underwriters rarely take into account the greater risk posed by shortening the maturity and causing a bank to lose a loan. Further, there is often not a robust understanding of how covenants, market stress testing, lease diversification, tenant quality and pricing interplay with determining cash flow stability at the property level.
What Does Matter
Credit officers should be focused on lease terms and lease mix to mitigate credit risk for commercial properties. The more diversified the underlying property leases are, the more stable the cash flows and the less lease term matters. The same goes for the credit quality of the tenants – the higher the credit quality, the less important lease term is. This last point is nuanced but important. Credit quality of tenants is important because it is this credit quality that mitigates systemic risk of the property (for example a broad recession). Renewal risk becomes manageable when multiple tenants occupy the property. If the property already has sufficient collateral value (so that the loan amount is less than 60% of current market value) / cash flow (in excess of 1.5x) then average lease term as a measure of credit risk becomes much less important.
In similar vein, the faster the rent appreciation is, the less lease term matters. In some cases or markets, shorter lease terms results in greater future cash flows and lower default risk to banks.
Average lease term of a commercial property is just one of many factors that need to be kept in perspective. What matters more is the type of property, the property’s appeal/marketability, location and management. A loan term that exceeds average lease terms does not necessarily mean higher risk and can often be mitigated by smarter loan structuring such as requiring covenants that tie tenant performance to reserve requirements. Alternatively, greater rollover risk might be mitigated by nothing more than higher pricing. While it is important to analyze the current rent roll, know that the current tenant composition is a transitory factor and will change over time. Banks would be better served by devoting additional resources to underwriting some of the more important factors mentioned above.
Submitted by Chris Nichols on June 02, 2015