We always like to look back and see where underwriting and credit accuracy can be improved. Recently, we looked at almost 5,000 commercial real estate (CRE) loans from across the country that was underwritten in 2012. We looked at the property level cash flow projections to include revenue, expenses and net operating income (NOI) and then compared that to what has actually happened over the last 3 years. Our findings should give you some comfort to the conservative nature of your average underwriter.
Where Risk Is the Highest
As most banks know, credit risk is not linear. Each year is different and what starts out low in year one usually peaks around year 5. While 3 years during an improving credit cycle isn’t long enough to conclude that banks are accurate and that the 2012 vintage or earlier are safe from an economic downturn, the data does point in that direction.
Looking Back At 2012
2012 was a year that most banks put the recession safely behind them and moved from the defensive to the offensive. It was a year of very few surprises, but one that can be characterized by choppy growth. While housing showed some promise, GDP, job growth, wages and sales were all predicted to be stronger, but came in at lower than projected levels. It was a year that the Fed promised to keep rates “low for long” or until unemployment falls below 6.5%. In short, banks were hopeful, but had little support for a gang buster future.
Of particular note, it was also a time when manufacturing was just starting to come back, but some of this optimism was not reflected in historic property prices or cash flow projections. After years of troublesome and choppy NOI trends for industrial properties, banks were more optimistic on a relative basis.
How Banks Did
As can be seen in the chart below, in almost every category, loan underwriting was conservative and actual net cash flow did better than projected. In areas such as hospitality, multifamily, self-storage (Other), mobile home parks (Other) and campgrounds (Other) banks placed very little strength in future value. However, each of these sectors and subsectors wildly outperformed.
What Can Be Learned
The only negative is that in looking at the details, loan underwriters underestimated the future expense levels at almost half the properties. Higher labor, taxes, leasing expense, materials and insurance costs were only partially offset by lower energy costs (which was a relatively recent occurrence). That said, revenues also increased more than expected resulting in net operating growth as detailed above.
The other major trend that emerged in looking at 3 years’ worth of data is that metro markets outperformed rural markets (no surprise), but smaller, secondary or tertiary markets outperformed metro markets (which was a surprise). What many of these loans demonstrate is that suburban markets adjacent to metro markets have been stronger than expected. There was a subtle population shift from rural to metro post downturn, but by 2012, there has been an “urbanization” of suburban markets as little commercial centers have emerged around major cities. This has helped rents and lease rates in those areas.
The Future and Putting This Data into Practice
Your bank likely skews differently from this data, so it might pay to spot check your projections to see how accurate you have been over the last 3 years. Knowing your accuracy will not only give you a better handle on your underwriting practices, but will help with loan pricing accuracy and with portfolio management, as you can see which properties might need additional risk mitigation or what properties are at risk for refinancing (those with very strong NOIs).
2016 isn’t all that different than 2012, so we are hopeful that this outperformance on property net operating income will continue. In another 2 to 3 years, NOI growth and property appreciation will be sufficient enough to project a bank on this vintage or earlier should a downturn occur.
Submitted by Chris Nichols on March 21, 2016