By Brad Stevens
If your bank is average, your credit portfolio will contain a concentration of over 70% in real estate loans. While you might have the best intentions for underwriting real estate loans with the utmost of care doing what you can to maintain the credit risk may not be enough. Marketplace impacts will be magnified within your credit portfolio which could be troubling due to the level of real estate loans. Taking actions now to determine the embedded risk that your real estate portfolio might be carrying, will allow your bank to get an early jump on any problems that are arising.
Not all real estate loans are equal. On average, the risk spectrum will run from 1-4 family residential, the least risky, to construction and land development carrying the most risk. In the muddy middle is where most portfolios are concentrated. The commercial real estate segment is typically an area that holds the largest portion of outstanding credit. The non-farm, non-residential properties are made up of owner occupied as well as investment real estate holdings. The commercial owner-occupied portion carries moderate risk. The bank should have the entire relationship, including the operating company, so you should have a high level of confidence in the financial reporting. Catching any deterioration in the credit can be done early in these cases.
Understanding the risk associated with investment commercial real estate is crucial. The bank typically is blind to the true repayment source of the loan. It is not the owner; it is the tenants that occupy the building. A key question that is never asked and rarely answered is…. Would we lend directly to the tenants? Likely not, yet that is exactly what you are doing in investment real estate lending. You can get leases and rent rolls and feel a sense of misplaced comfort. The risk still lies with the operating company that pays the rent.
Over the past two years the entire real estate market has been shaken by the pandemic, civil unrest, business model changes and value bubbles. Any one of these marketplace impacts could cause a shudder in the risk level of your credit portfolio but add them all together and you can see why every bank should be concerned.
The pandemic has smashed a number of business models. Retail, restaurants, service companies, all have had to change in the way they interact with their clients or deliver their products. Are these tenants that occupy the real estate you have financed still there? Are they even still viable as a business? What changes do they have to make, and will they survive? If your lending staff has not completed a site visit in the past 60 days, they need to. The staff should also be talking to the borrowers to understand the rent collections. Are tenants paying? Are they on time? Which tenants are struggling, and which are doing well? Concentrate on the tenants most impacted by the pandemic or facing a business model change. If the landlord is concerned about them, then you should be also.
The key to success in real estate is location, location, and location. While the location did not change, conditions may have. The civil unrest and rise in homelessness have impacted specific areas of our cities. Traffic in some of these areas has diminished as people do not feel safe. Is this happening in the neighborhoods surrounding your loans? Again, time to do a site inspection and discuss how the conditions have changed with your borrowers. An updated appraisal may uncover valuation issues, including changing cap rates, which could imperil the quality of the loan.
Office space is opening nationwide as companies allow more and more of their staff to work remotely. As leases expire, the key questions to ask are will the tenants stay, reduce their footprint, or are they leaving altogether? Many areas are experiencing rental discounts or concessions which, could impact the future cash flow as well as the value of the property. Proactive discussions with the owners as well as an updated appraisal are warranted. Re-underwriting the cash flow is likely needed.
We have all watched the rise in residential housing prices. A major concern is that the values today will collapse tomorrow. We all remember the Great Recession. Beyond the cushion we might believe we have in the collateral of our residential loans; affordability is a rising concern. With the level of inflation, homeowners that marginally qualified for their first mortgage as well as their HELOC, are likely to fall behind in payments. An early warning sign here is HELOC’s that continue to advance monthly, some even paying the interest due with an advance. Monitoring this portfolio now is critical to avoid losses later this year.
Beyond internal monitoring, re-assessing the values, updating the rent rolls and possibly updating the underwriting on cash flow, your bank may consider a select loan review of the real estate portfolio. Outside of finding those clients that could be facing trouble, you could also ensure that the documentation is up to date; bomb proof as we typically say. If not, prior to the borrower becoming stressed, corrections can be made to shore up the loan file.
Your real estate portfolio, the largest portion of the largest asset you have has been impacted by multiple marketplace events over the past two years. Before the risk level gets out of hand, now is the time to have your staff do site visits, update the monitoring of the files, order select appraisals or valuations, update the cash flow analysis as well as completing a loan review to protect the bank. Catching just one declining credit early will more than pay for any expense you incur.
Brad Stevens is principal and founder of SRM, LLC.
