Way back in high school you may have heard about the ancient Greeks and their myth of Scylla and Charybdis. Depending on how you wanted to read the myth, they were sea monsters or natural nautical dangers—one a dangerous rock shoal and the other a hazardous whirlpool. They lay so close to each other that the navigator attempting to travel in that part of the Mediterranean faced a difficult task. If he steered to avoid Charybdis, he risked Scylla. And vice-versa.
Bankers sometimes face similar challenges.
Of late, regulators are actively raising concerns about bank commercial real estate lending practices. Competition and desire for growth are causing many in the industry to loosen credit standards. So, bankers face another manifestation of the chief credit officer’s Scylla-and-Charybdis challenge—knowing when to stretch for volume and when to pass for safety.
Some might skip the mythology and just say they were caught between a rock and a hard place.
Where’s the balancing point?
Years of economic recovery have led to improved business activity. With rising rents and low interest rates, historical performance measures for income-producing properties are positive and improving. Now is the time to think about which borrowers are most likely to exhibit sustained performance over a full business cycle.
All of the largest banks do so, as do many regional banks. These banks use metrics that are derived from the volatility of cash flows for different property types and tenant composition over complete economic cycles.
Community banks lack the data and perhaps quantitative skills to do the same. Large banks have a broad portfolio to manage, but for good reason community banks often are geographically constrained.
Most community bank risk-rating systems for income-producing CRE take into account the well-accepted ratios regarding debt service coverage and loan-to-value. In addition, owner capacity and global debt service coverage are weighed, as well as a variety of borrower and property specific characteristics that come with knowing your market well. When it comes to the numbers we naturally rely on current and historical data.
Getting a fix on CRE loans’ economic sensitivity
The underlying challenge is to determine if the historical and current data that reflect a good loan opportunity is likely to remain in place, especially during bad times. And if not, to what degree performance will deteriorate.
Simply stated, how closely correlated are the cash flows to overall economic circumstances?
Let’s apply some common sense, one of the community banks’ strategic advantages, to move toward an answer.
Some industries and property types are known to be sensitive to economic factors, while others demonstrate relative insensitivity.
If you have the data regarding the performance of your own portfolio, consider gathering it to assess which property types and industries in your market exhibit such characteristics. In doing so, it is important to measure performance statistics as a dollar percentage of the underlying population of those loans in your portfolio.
If you don’t have the data, use general criteria to begin your evaluation. For instance, it is well known that the performance of loans to hotels will be economically sensitive—at least those without a national brand—while loans to medical office facilities will not be. Try putting each of the loan types into one of three buckets—high, moderate, or low economic sensitivity.
Typically in the high category are hotels/motels, retail, and (the infamous) restaurants and bars. In the low category are multi-family (20+ units), medical offices, and perhaps even franchise fast-food establishments. General industrial and warehouse, smaller residential properties, and retail/office may well comprise the moderate category.
Local markets may vary, of course, so use your experience as a guide.
Looking at the ratios
Now think about how the standard underwriting guideline of 1.2x debt service coverage ratio (DSCR ) and perhaps a 75% loan-to-value ratio (LTV) apply to each category.
When the economy is in recession, the properties that exhibit low economic sensitivity are far more likely to continue performing. They will resist downgrade, delinquency, etc.
On the other hand, a property of high economic sensitivity is more susceptible to reduced net operating income and therefore to downgrade and delinquency. Further, the LTV ratios for high economic sensitivity properties will be subject to far greater deterioration than the more stable ones.
The best place to recognize these differences is in your risk rating grid. A loan to a retail facility that exhibits 1.2x DSCR and a 75% LTV should not carry the same risk grade as one to a medical office building, for example. By insisting on realistic ratings, you may also enforce more accurately portfolio management standards.
No one wants to foreclose on one of these properties at the very time that potential buyers are suffering and banks are not lending.
A word about “owner-occupied” properties
Community bankers tend to think warm-heartedly about owner-occupied CRE lending. There is good reason for that, but reviewing the bank’s underwriting calculations in this area may prove fruitful.
Very often, the building in which the business operates is held in a separate entity from the business itself, which is the tenant in the building. The underwriting process for these loans often looks at rents the operating business must pay under the lease and adds to that income cash flow generated from the operating entity. Inherent in this procedure is an expectation that cash flow from the business is always available to service real estate debt.
Consider, though, how consistent that cash flow is over time, and whether all of it can be devoted to sustain rental payments. Operating businesses have a variety of calls on their cash flow. All C&I lenders recognize that; hence they look at sources and uses of cash.
The lesson here: The potential volatility of the cash flow from the business should likewise be recognized in the CRE risk rating matrix.
A chief credit officer who recognizes that 1.2x DSCR and 75% LTV provide a wide range of buffer against downgrades, delinquencies, and losses during stormy times ahead will have a clearer path to meeting the Scylla-and-Charybdis challenge all lenders face.
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