Loan pricing depends on many things including cash flow, geography, property type, tenant mix, lease structure, borrower, loan structure and leverage. While loan pricing is primarily driven off cash flows, banks spend an inordinate amount of time worrying about loan-to-value (LTV), but little time adjusting for pricing. Today, we look at the relationship between LTV and loan pricing using data from the month of March.
Looking at a group of 26 commercial real estate loans for March from across the country, you can see there is only a loose relationship between pricing and LTV (Note the weak 24% correlation). March is similar to other months, as property and borrower level factors usually override the influence of LTV which is why the correlation isn’t stronger. Further, the presence of loan structure factors such as prepayment penalties or adjustment features has about an equal influence on a loan’s pricing as LTV.
We have graphed the loan data below and added a trend line:
How To Use This Data
There are a couple takeaways here. One lesson is to understand the role of LTV and how it impacts expected loss compared to other credit metrics. Depending on your geography and type of credit, LTV is likely in line with the 24% correlation. This begs the question - is your bank allocating the right resources in its underwriting? Since stability of cash flow has a larger impact on risk, most banks expend more resources in analyzing expected future cash flows, rent rolls, expenses, etc. If this is your bank, then it pays to make sure that pricing can be adjusted to compensate for risk.
For LTV, the data shows that pricing is adjusted approximately 23 basis points for every 10% increase in LTV. Information like this helps when facing competition and it also is important to make sure that pricing and risk are aligned. To that point, if you look at the plot above, you can see there is strong competition in the 80% LTV range. Some banks adjusted pricing in order to mitigate risk, while others did not.
Understanding the importance of your major credit metrics and the impact on pricing can help your bank win more transactions and better align risk with return.
Submitted by Chris Nichols on April 02, 2015