When stress testing any given loan, there is a fine but correlated relationship between cash flow, property values, and expected losses. In this article, we gather our data and present a composite CRE benchmark in which to calibrate your bank’s model or expectations. At a minimum, this data will help your bank hone their credit shock assumptions and give you an idea on if you have adequate reserve levels at both the loan and loan portfolio level.
The Historical Mistake
It was mid-2007 and net operating income (NOI) on properties had a sturdy track record of accelerating. While banks knew retail was slightly overbuilt (sound familiar), most other sectors still had the green light for lending. After the first signs of stress appeared in 4Q of 2007, by 1Q 2008 we saw NOI growth rates appreciably slow. Unfortunately, banks continued to use projections that were anchored in the past as most lenders looked at 2006 as a reference point, the peak of the last cycle (and the last full year of data).
By the end of 2008, every bank knew they had a problem given the events in the market, but few moved quick to use the data available and risk-adjust their loan values in order to gauge the level and exact location of risk in their portfolios. To put this in perspective, capitalization rates on quality bank properties went from a low of 5.6% in 2006 to 8.2% in 2009 (see below). Problem properties blew out to 20% or greater.
In retrospect, banks should have started to allocate workout dollars and reserves somewhere around May of 2008 when transactional value cap rates moved materially up sending the first clear signal that there was a problem. Another signal was that was present in late 2005 was that implied cap rates from appraisals started to increase which should have put banks on alert. For that matter, the even stronger signal was corporate bond defaults which is one of our early warning signs. Public markets tend to signal private markets by an average of six to nine months with a high level of correlation (more on this in the future articles).
Regardless of early warning signs, by late 2008 banks knew that had a problem and started to take action. Unfortunately, few community banks had a stress test to fall back on so few had a feel for the sensitivity of cash flow, value, and losses.
Getting It Right Going Forward
Since cash flow is king, it is important that every bank loan above a certain dollar amount be stressed given a set of vacancy, rent, expense and absorption assumptions. To get a feel for how these are related, we look at approximately 40 properties that had a clear default and were subsequently liquidated to see the actual evidence.
Similar to 2006, we saw implied cap rates averaging around 5%. Most banks chose to underwrite these properties at a conservative 7% cap rate. Once these loans were declared in default, however, actual experience showed that these cap rates averaged 16% with a high of 45%. That is a stark difference from a 7% cap rate level.
Since CRE cap rates are derived from transaction prices and prices are a function of cash flow, as cash flow decreases cap rates go up sending property prices down. As cash flow gets reduced, the probability of default increases at banks while the change of cap rates immediately impact the loss given default. The result is a quick rise in expected losses.
In analyzing defaulted properties, as can be seen below, banks can easily absorb small changes in cash flow. A drop of 10% of a properties cash flow increases the cap rate from 7% to approximately 9%, but the loss given default for the loan isn’t impacted. However, at a 30% decrease in cash flow, the cap rate jumped to 16% and the loss given default increased to 20%.
The takeaway here is a quick rule of thumb that will make any bank commercial real estate lender better – for every 10% decline in net operating income, cap rates increase by approximately 1.5%. Further, bank reserve levels can normally handle cash flow decreases by about 33%. More than that and the combination of a higher probability of default and a higher loss given default usually pass the 1.25% expected loss level which is about equal to an average bank’s reserves. This takes into account property appreciation since underwriting, loan amortization, lower property values, non-paid interest, accrued property expenses and workout costs.
Putting This Into Action
This analysis should help commercial real estate bankers better understand the sensitivity of cash flow decreases in property values and loan losses. While this data will be different for various regions, property types, properties, and borrowers, it should serve as an easy to reference benchmark to help in underwriting loan value and give bankers a sense for the severity of rate shocks to apply. As we get deeper into this credit cycle, banks need to start increasing their reserve levels to offset the risk of more severe future shocks and greater sensitivity in cap rates.
Submitted by Chris Nichols on April 13, 2017