“Real estate is important again!” I remember hearing a senior credit officer saying this to a group of commercial real estate lenders at an MBA conference in 2009, but he didn’t explain when or how the real estate – the security for repayment – had become unimportant. With pressures to increase returns, the growth of real estate prices year after year makes it easy to believe that this is the normal state of affairs, but the cyclical nature of commercial real estate means that periodic correction is also part of the normal state. Lenders can protect themselves from downside risks, but only if the real estate remains important. Relying on credit tenants, repayment guarantees, cap rates and cash flow projections is not enough.
The Need for Comprehensive Risk Management
A post-recession study conducted by the Office of the Attorney General (OIG) concluded that “Boards and management at too many other institutions pursued profits through growth and higher-earning, risky assets, in an era of easy credit, while lacking robust risk management practices…”. Rapid loan growth, inadequate risk management practices and internal controls, asset concentrations in commercial real estate and acquisition, development and construction (ADC) loans, and inadequate capital reserves were cited as primary drivers in a majority of bank failures during the recession. Risky funding plans and incentive compensation programs were also identified as contributing factors.
An additional study (see here: EVAL-13-001) found that active boards, strong management, sound credit administration and underwriting, and adequate capital reserves helped lenders with a high concentration of ADC loans avoided significant impacts to their financial condition – “the strategic decisions and disciplined, values-based practices and actions taken by the Boards and management helped to mitigate and control the institutions’ overall ADC loan risk exposure…” Further problems were identified when that banks participated in loans managed by others failed to perform independent due diligence and monitoring of credits. By implementing a comprehensive risk management plan, lenders can protect themselves from changes in the CRE market.
Delineating Asset Risks
Regulators require the completion of an appraisal to support all loans, but in the absence of obvious problems, appraisals typically rely on certain assumptions about the property; there are no adverse environmental conditions, historical maintenance has been performed on a routine basis, no material building deficiencies are present, and no unusual repairs or replacement are expected in the near future. Similar assumptions are made about “comparable” properties used in development of the estimate of value. Unfortunately, hidden conditions frequently invalidate these assumptions, resulting in a lower-than-expected value.
A property with a new roof, chillers or elevator equipment, for example, will be worth more than one that requires related repairs or replacement in the next few years. The impact of contamination can be even more dramatic; sometimes disrupting use of the property, requiring cleanup expenditures that exceed the value of the property, or limitations that affect the redevelopment potential of the property.
Detailed structural and property condition assessments, environmental site assessments and site surveys must be performed in order to fully delineate how an asset will impact security of repayment.
Construction: an Added Layer of Risk
Additional research conducted by OIG showed that construction lending poses greater risk of loss. Before making loans, lenders who performed well during the recession implemented processes to understand improvements, and to monitor work and control funding during the construction process. Pre-loan evaluation of plans, contracts, approvals, budgets and supporting reports (Document and Cost Review) can help lenders identify problems before committing to the loan, and construction progress monitoring can give early warning of budget increases, delays and deviations from approved plans to help assure completion of the development and value of the finished improvements.
Lenders profit from taking risks, but gambling on unknowns can lead to disaster. By establishing a comprehensive risk management program, including strategies, underwriting and controls to identify risks and manage risks, lenders can enjoy the benefits of commercial real estate, while minimizing downside risks that can be catastrophic to a portfolio.