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.
In the latest quarter, community banks under $5B in total assets held 18% of all assets in 1-4 family mortgages, 31% of all assets in commercial real estate, 11% of all assets in mortgage-backed securities and commercial mortgage obligations, 3% of all assets in farmland and 6% of all assets in other non-earning real estate assets (mostly branches and corporate offices). That means that 70% of all assets at these community banks are tied to performance and value of real estate. That is a high concentration and rightfully a concern for many in the industry.
It is no wonder that bankers are trying to diversify away from real estate to manage risk (and still generate profits). The natural inclination is to devote more resources to C&I lending. This area of lending has some attractive features including cross-sell opportunities, largely the ability to capture the account’s deposits.
Unfortunately, when you analyze the profitability on many C&I accounts, the risk profile and profitability performance actually create more risk, not less on an aggregated basis. Some of these reasons are not that obvious, so it is important to understand the following:
- Acquisition – C&I has some of the highest acquisition costs of any lending area. Sales closing times are long, underwriting is intensive and account management is costly. Because of these factors, many accounts lose more money for banks than the diversification risk they are trying to solve.
- Competition / Pricing – Intense competition has decreased loan rates and increased deposit rates, hurting the profitability profile. Banks without a loan pricing system often don’t take into account risk, cost and loan size when pricing. As such, some of the most irrational pricing in banking can be seen in the C&I sector.
- Credit Risk Profile – Usually a line of credit is required for a C&I loan which, if not managed right, can destroy all hopes of profitability. Few bankers realize how much more risky a line of credit is compared to a drawn term loan. Further, if the line of credit is not controlled in the right fashion, it can take a diversified credit and turn it into a credit that is correlated to real estate. Lines of credit usually don’t have the profitability of a term loan, yet often get drawn on when credit risk is at the highest. As such, bankers need to be extremely careful when structuring, underwriting and pricing lines of credit.
- Maintenance Cost – In addition to acquisition costs and the risk profile of a line of credit, maintaining a C&I credit is more costly than a real estate credit. Thus, pricing needs to be adjusted for this risk.
We analyzed the net charge-off performance and correlation of various loan segments for community banks from 2000 - present. We looked at all reportable loan segments (including C&I, CRE, C&D, multi-family, 1-4 residential, credit cards, home equity, and consumer). The highest charge-offs were in the credit card segment, which hit a high of 12.36% in 2003 and were 9.36% in 2009. The next highest charge-off category was construction and development, which hit a high of 3.93% in 2009. Credit cards and C&D loan charge-offs were marked outliers. No other loan category exceeded 2.28% in charge-offs in any year we analyzed. We were not surprised to see that the C&I loan charge offs were also high – peaking at 1.8% in 2009. This was substantially worse than CRE, which reached 0.58% in 2009. When factoring in pricing, cost, credit quality and cross-sell opportunity, we have long maintained that the average C&I loan has a lower ROE to the bank than the average CRE credit. The chart below shows some of the charge-off numbers.
One thing that does surprise many bankers is the fact that the C&I loan net charge-off rate is 97% correlated to total bank charge-offs and is 89.5% correlated to total real estate charge-offs. The statistics show that community banks were not able to effectively diversify their portfolio between 2000 and today by booking C&I credits. Strikingly, consumer loan charge offs showed a 22.9% correlation to total bank charge offs and credit cards showed a 15.6% correlation to total bank charge offs. Community banks were able to diversify their loan portfolio much better with these two loan categories. We are not recommending banks pursue credit card and consumer loans, as many other factors must be considered in addition to correlation to the loan portfolio, but the statistics do highlight an education that many bankers miss – you can reserve against credit risk, but most banks don’t reserve against correlative risk. As such, many banks that traffic in both credit cards and real estate have a much lower risk profile than the average bank despite having higher loss rates.
We did more research to help explain why community bank C&I portfolios were so ineffective in diversifying loan performance. In addition to some of the factors mentioned above, there are some additional obvious answers. When we looked at community bank’s C&I loan portfolios, we discovered that the vast majority were just real estate-related businesses without the real estate collateral. As such, there was no diversification in cash flow. For example, the Building and Development subsector of the C&I category has a 64% correlation to the broader real estate market. We saw this subsector as one of the major components of community bank’s C&I portfolios. Retailer credit is another large sub segment of community bank C&I loan portfolios which, unfortunately, has a high correlation to real estate (49%).
For diversification, banks with high real estate concentrations should be extra careful to price and structure their C&I exposure. On a macro level, banks need to be cautious of the following sub-segments of C&I: building and development, retail, automotive, chemicals, plastics and food services. All these areas are highly correlated to real estate.
Instead, banks should seek out C&I credits that demonstrate the lowest correlation to their real estate portfolio. In order of preference those sub segments are as follows: energy, forest products, beverage and tobacco (all have less than 0.1 correlations to real estate). For the best diversification, banks should attractively price, devote resources and focus on utility lending, as that is the one sub segment that currently has a negative correlation to real estate.
In conclusion, the vast majority of community banks’ balance sheet is tied to real estate. The top performing banks are taking steps to diversify either through SBA loans, wholesale purchase programs or generating cash flow from non-credit services. We have been helping find C&I loans in sub segments that present effective diversification benefits and still deliver sufficient yield for 8% to 15% ROE.
Submitted by Chris Nichols on January 06, 2015