If you think the economy is going to muddle along, then you should skip this post as our analysis isn’t going to make a difference in your future - 2021 will be much the same as 2016. However, if you think the economy is going to pick up steam, or if you think the economy will get weaker, then today’s data could make a difference over the next couple of years. As can be seen by the graph below, commercial real estate risk continues to increase and the risk on new community bank loan production is up 6.5% during the first half of this year compared to last year.
Are Underwriting Standards Slipping At Community Banks?
The answer is yes, but this is our point today. According to most community banks you ask, they will say that their underwriting standards, exception level and average rating have not degraded over the past several years. The Federal Reserve Board’s April 2016 Senior Loan Officer Opinion Survey (HERE) supports this notion. So what is happening?
The Impact From Asset Prices
In the last 90 days, we have seen a slowdown in commercial real estate appreciation. This has been expected due to the record wide difference between market multiples and the discounted cash flow valuations of properties. As worldwide capital looks for a home, capital from the Middle East, Asia and Europe, money is being poured into US properties. As a result, capitalization rates continue to be near record lows in many parts of the country.
This has elevated the risk for community banks. Higher relative property valuations combined with the recent slowing of appreciation is the primary driver of this risk. Banks that underwrote properties last month at a 75% loan-to-value, now have four times higher expected loss rate under a stressed scenario than a loan they wrote in 2011 at a 75% LTV.
As we get later in the business cycle, this trend will continue.
What If The Economy Gets Stronger?
The other interesting aspect of this data is the dispersion of property level performance. That is, many markets are uneven. Metro areas like New York, San Francisco, Miami and others are booming. Should the economy pick up, interest rates have the possibility of sharply increasing. This would create a stressed scenario as property appreciation would slow aggressively and borrowers in slower markets would get hit with higher interest rate costs without the corresponding increase in rents. This would also result in higher expected loss rates per the graph above.
Putting This Into Action
Understanding where we are in the credit cycle and building in adjustments to risk on underwriting and pricing is a good first step. We also recommend that banks increase credit quality by going after higher quality borrowers. Yes, banks may have to give up 30 to 50 basis points in margin, but that pales in comparison when you think about the difference between an 8% principal loss and an expected 2.5% expected loss. Borrowers that are accepting Libor + 3.00% pricing (or greater) are either not aware of the intense loan competition that is taking place or run the risk of having a credit that contains more risk than is observed.
Submitted by Chris Nichols on July 25, 2016