Do you treat all cash flow the same? That is, does a property with a 1.25x debt service coverage get a “3” rating no matter what type of property it is? If so, your bank is most likely mispricing risk which will hurt performance over time. Every waking business day, bankers have to make decisions and the ones with the best information will have superior performance over time.
As discussed in several past blog posts (for example, here and here) different industries and different real estate projects have different volatility in their cash flows. This volatility represents risk and community banks should evolve into adjusting their credit grading systems to account for this risk. As can be seen in the diagram below, an apartment building and a office building with 1.25x debt service coverage does not present the same risk profile.
For example, let’s say your bank wanted to achieve a 0.50% probability of default ("POD") for a credit grade of “3”. This is a fairly strong credit and current pricing is averaging about 217bp over Libor and the risk-adjusted return on a real estate loan is approximately 11% for a 10-year loan. What does this credit look like? Well, it depends, as different projects have different risk.
To answer this question, we looked at current 3-year, point-in-time cumulative probability of defaults and held our model constant at 0.50%. We then analyzed what cash flow would be required given the current cash flow volatility over the past 12 quarters. The results are presented below.
Loans on multi-tenant regional malls performed the best, had the most stable cash flow within that risk range and required a 1.35x debt service coverage to equate to a 50bp probability of default. By comparison, because of greater cash flow volatility, office properties require a 1.5x coverage while limited service lodging requires a 1.90x debt service coverage to equate to the same 50bp in default probability.
Banks that treat all cash flow the same end up underpricing some risk and over pricing others. This results in an inefficient allocation of capital and when credit stress occurs, losses are then monetized and capital is eroded. Conversely, smart borrowers will take advantage of banks as they have in multifamily. Here, as can be seen in the chart, while cash flow volatility is low, it is not that much lower compared to industrial property. However, pricing is almost 80bp different between the two asset classes which means many banks are subsidizing apartment owners with their own capital.
Luckily, it is a good market for risk so the odds of default are low. However, this will not always be the case and banks that start to get more granular in their credit grading and take into account cash flow volatility for their real estate and commercial properties will come out with higher returns over time than banks that don’t.
Submitted by Chris Nichols on June 10, 2014