Why Commercial Real Estate Loan Spreads Continue To Tighten For Banks

CRE Bank Loan Performance

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. Since cash flow is so important, below we give some current benchmarks to analyze the property level cash flow underlying your CRE portfolio and give some thoughts on where we are in the business cycle.  

 

The Current State Of CRE Cash Flow

 

Commercial property cash flow growth was stellar and while not as good as 2013, was still a respectable 2.5% for 2014. Properties in major metro markets cooled with a 1.1% rise, while secondary market properties tended to produce about 3.2% growth according to Moody’s/ RCA CPPI indices.

 

Higher cash flows, of course, mean greater property appreciation, and for 2014, CRE properties appreciated 13.9% on average with major markets jumping 14.3% and secondary markets rising 13.6%. To place this in perspective, the 10-year average annual price appreciation for commercial properties is 4.8% on average with major markets averaging 6.9% and secondary markets averaging 3.1%.

 

If this was not good news enough, 2015 is off to what could be a record year as property, driven by cash flow increases has jumped 4.7% for the quarter which is over an 18% annualized pace.

 

On a loan type basis, hospitality has had the best performance of any major subclass as revenue growth is almost 7%, while expenses have been reduced. The result is a 10.5% growth in net cash flow. As a result, credit risk has dramatically been reduced, probabilities of defaults are down and pricing has remained stable at Libor + 3.19%. Other sectors that have done well include multifamily and other, most notably self-storage, RV parks and country clubs.  Below are the national benchmarks to gauge your properties and compare them to the national average for revenue, expense and net cash flow growth. 

 

CRE Loan Performance

 

Are We At The Top Of The Market?

 

Astute bankers will look at the data above and notice that property price appreciation has dramatically outpaced cash flow which is a sign that we are in an overheated market. Right now, too much liquidity is chasing too few assets which have resulted in inflated property prices. Further, when analyzing rent roles and underlying tenant economics in major markets, a significant number of tenants are not cash flow positive. The conclusion is property price growth can’t last and we are surely in a bubble.

 

However, bubbles can stay inflated for a long time. Despite pending rate increases, monetary policy will remain accommodative for some time further fueling real estate price appreciation. Meanwhile, the strong property level cash flow growth will continue to support price levels. While the margin between property prices and cash flow growth are expected to revert to the mean, it appears we have several years to run. Growth will slow and credit risk will increase, but we predict credit risk will remain below average. Look for slowing in major markets for 2015 and 2016, while secondary and tertiary markets will continue to put in 1.6% or better net cash flow growth performance for the next two years.