We are often asked what is the single best measure of lending risk? Is it loan-to-value ratio? Is it interest-coverage ratio? Is it debt-service-coverage ratio? Is it liquidity ratio? While there is no single measure that can be used and each of these measures are important in various underwriting circumstances, if we were stranded on a deserted island and could only bring one tool to measure our underwriting risk, it would be debt-to-cash flow ratio (this is typically called the “leverage ratio”). The leverage ratio is the measure of the borrower’s debt divided by t
If you listen to the news pundits, there is lots of talk about asset bubbles. To figure out if banks are lending into inflated asset prices we turn to the data for answers. Since valuation is a function of future cash flow, having a more accurate vision of the future is helpful when lending. Once predictive factor to alert commercial real estate lenders is when supply outstrips demand by more than a 2-to-1 ratio. When this occurs there is better than a 60% chance that cash flow remains flat or even goes down, thereby hurting property values.
All bankers agree that the more equity an owner has in a property or business, the better the credit. While statistically true, the real question is how much does equity matter? Or, a similar question, what is that equity worth? The answer is that it depends on how much you are talking about and what type of loan you are talking about. In the companion graph, we have charted the probability of default with the ownership equity percentage. The solid line in black represents all commercial bank loans, while the dashed line are just commercial real estate loans.
As of the end of June, commercial real estate is the second largest credit risk on community bank’s balance sheets, composing almost 29% of the loan portfolio - just slightly behind residential real estate exposure. On a dollar basis, we are now approaching some of the highest levels in history and are on track to break the record in the next year, a record set back in Dec, of 2008.
Last week the RadioShack earnings announcement and restatement that it will close 1,100 locations sent bankers scrambling back to their credit files to see if the beleaguered electronics chain composed any part of their commercial real estate rent rolls. It turns out that that for about 100 loans, there is exposure with an estimate of 36 of these at community banks. Luckily, Radio Shack has been downsizing and has gone to smaller and smaller footprints so that on average, the stores now make up less than 10% of the rentable space at these retail centers.
How is your lending expertise when it comes to self-storage loans? Since the lending sector is risky compared to other traditional bank lending lines, it pays to understand not only the drivers of risk, but now since the rise of data analytics, what factors help tip the probabilities of success in your favor. This article highlights a continued trend in banking of how lenders can take a sector with a higher than average risk, and through better underwriting, monitoring and management, can reduce their risk in almost half.
Next to C&I, commercial real estate ("CRE") loans have been one of the best performing asset classes for banks in 2014. Spreads continue to tighten on CRE and are expected to suck in another 8bp by year end making the future look bright. With banks coming up on their mid-year asset allocation review, all looks stable for the majority of bank asset classes with the exception of the difference between commercial real estate and residential mortgage holdings on bank’s balance sheet.
2013 property cash flows are starting to come in at many lenders and we have been taking a look at the data to see what insights can be gleaned that could give us an advantage. Combining bank data with data from the public markets, we can get a statistically valid sample size of over $130B worth of properties in almost all major metro and suburban markets (about 14% of the total CRE market). The below data may help banks when pricing and will give a clearer view of the risk profile when underwriting.
One of the classic mistakes that most of us made back in 2006 is not taking a forward looking view of credit. We underwrote credits based on current debt service coverage and current loan-to-values, instead of using forward values. This was a mistake, as had we looked ahead, we would have seen a large portion of the economic downturn.
A look at 134 commercial real estate loans that were just sold last month with recent appraisals reveals some interesting data points for banks. The sale price was higher by about 10% than the appraised value. In looking at the details, appraisers placed a heavier weight on current capitalization rates versus investors that tend to look more forward. This begs the question – how accurate are commercial real estate appraisals and should banks be basing loan amounts on them?