When a bank forecloses on commercial property (or has the option to foreclose) there is always a question of do you spend energy working out the property in hopes that the value comes back or do you sell the property and take the capital charge? To answer the question, we looked at analysis on 150 loans whose underlying financed properties had payment problem and analyzed appraised values over a period of time to determine when a bank should either push the borrower to liquidate the property or foreclose and liquidate the property themselves.
When analyzing your bank’s commercial real estate (CRE) portfolio, there is one metric that means more than all the rest of the other factors combined. Of course, that one factor is debt service coverage and recent performance helps explain why spreads are contracting as much as they are. Calculating changes in a property’s cash flow account for almost 60% of commercial loan’s default risk. As any banker knows, cash flow coverage is highly correlated to defaults and understanding changes in the cash flow can help foretell of pending problems or forthcoming good times.
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.
If you are a large bank, the share of commercial real estate (CRE) as a percentage of your balance sheet is likely slightly less than 5%. However, if you are a community bank, the share is likely over 20%, and growing. Even when viewed as a percentage of Tier-1 capital, larger banks hold about four times for commercial real estate exposure. That is a pretty big difference and CEOs (plus risk managers) should at least be asking the question as to why.
On this Earth Day, we are happy to report that doing right by the Earth can also help your borrowers and shareholders. When you underwrite your next loan on a commercial property, it might make sense to understand the property’s “walkability” or ability to walk from the property to nearby amenities such as public transportation, markets, parks and shops. The easier it is to get from your collateral the more likely that property will appreciate in a good market and hold its value in a down market. This goes for office, retail and multifamily.
For many community banks, a concentration in real estate lending may be an issue. This is especially concerning given the recent decrease in capitalization (cap) rates across many geographies and property classes. While community bankers have a difficult job trying to diversify their balance sheet away from real estate, we wanted to present a couple quantitative points that will make the job of risk management easier for banks.
Like Degas obsessed with dancers, bankers have been brought up to obsess over the composition of their loan portfolio. Egged on by our examiners, auditors and random pundits, we slice and dice our loan portfolios as if it means something and pat ourselves on the back when we can show a nice pie chart with lots of even looking slices. The reality is many of our sectors move together and offer little in the way of diversification. When the economy turns, tenants aren’t looking for new office space any more than they are looking for new industrial space.
Last week the boys and girls at the Joint Regulators (The FFIEC, plus SEC, HUD and others) rolled out the final rule (Final Rule) set (found HERE) that structures risk retention under Section 941 of the Dodd-Frank Act for bank assets destined for securitizations.
Statistically, a “hot hand” in basketball doesn’t exist. In a detailed analysis of the 76ers and Celtics plus controlled experiments with Cornell’s varsity teams, researchers found that streaks were just positive random sequences with little evidence of correlation between outcomes and successive shots.
Football coaches, like bankers, often ignore the data. Take 4th down conversions for example. We see this week after week where college and NFL coaches punt or kick a field goal where statistics indicate that they should go for it. Look at the chart below and you can see that coaches normally don’t go for a 4th down conversion (by a factor of more than 5) unless they are put in a situation where they have to, usually in the 4th quarter. Statistically, that is odd.