Each lender has a particular style and philosophy regarding certain asset classes and loan types. Understanding a lender’s perspective on underwriting is an important step in establishing a mutually beneficial relationship. With any originated loan there is always risk of a potential default, which may or may not have been directly caused by the borrower. Lenders are not in business to make bad loans or force a borrower into a situation that will result in the borrower losing their property. So as a lender is underwriting a proposed loan, they must be cognizant of all the potential risks associated with that particular transaction along with potentially unforeseen external factors (i.e. a pandemic).
The Office of the Comptroller of the Currency (OCC) lists seven types of risk associated with commercial real estate lending (Credit Risk, Interest Rate Risk, Liquidity Risk, Operational Risk, Compliance Risk, Strategic Risk and Reputation Risk). While all these risks are real for a lender (particularly a federal or state regulated bank), we will review those risks directly addressed in the underwriting process, including Credit Risk, Interest Rate Risk and Operational Risk.
Credit Risk encompasses most of the focus when underwriting a proposed loan. The below factors have a direct correlation with the market value of a subject property and as they change over time the market value may as well.
Changes in market conditions can have a huge impact on the subject property, and while not all changes are foreseeable (i.e. a pandemic), lenders are looking closely at the quality of tenants, conditions and terms of a lease, etc. to gauge how well a tenant(s) can weather a storm. As changes in vacancy can certainly impact the borrower’s ability to make debt payments, changes in the area vacancy rate may also have an impact on the market value of the property. While this may not impact a borrower’s cash flow directly, significant changes in area vacancy rates can impact the borrower’s ability to refinance or sell a property, as the adjusted area vacancy rates are a factor in underwriting for both lenders and buyers. The primary mitigant for market condition risk is the Loan-to-Value (LTV) that the lender is willing to lend. The lower the LTV, the more equity there will be in the loan, which provides a larger cushion to account for fluctuations in market conditions.
If a borrower does not have a fixed Interest rate, then interest rate changes can have a significant impact on their ability to cover the debt service of a loan. In today’s environment of low rates, locking in long-term fixed rate financing addresses this risk. As interest rates rise, however, many borrower’s may opt for floating rate financing to try to reduce the carry costs, so the lender has to look very closely at interest rate sensitivity to gauge the risk and the borrower’s ability to handle adjustments in debt service.
While environmental liability laws have changed over the years in favor of lenders, lenders still require some form of environmental assessment on a property. The reason is any contamination to a property may negatively impact the market value of the subject property and make it nearly impossible to liquidate without an adjustment to the sale price or remediation, which may be very costly. Potential remediation costs also may impede a performing borrower’s ability to service the debt.
Operational RiskThe OCC views Operational Risk as a lenders ability to maintain and monitor performance of loans, including, if applicable, controlling disbursements for construction loans. At the corporate level, this risk is mitigated through the implementation of systems and sound policies and procedures.
Similarly, lenders want to know that a borrower understands the intricacies of managing a commercial property and has a solid plan in place. This plan can be hands off for certain real estate investors or through third party providers that collect rent, maintain the property and handle repairs. I would also encourage borrowers to maintain a good relationship with a qualified local commercial real estate agent that can keep them up to date on the market and be ready to find replacement tenants. Borrowers need to be proactive when addressing Operational Risk, and that is why a solid business plan is a great way to mitigate this risk.
The other risks listed by the OCC are risks that lenders must address at the corporate level:
Interest Rate Risk
Just like borrowers, lenders have a cost capital and in the case of bank must pay depositors, or for non-bank lenders, they must pay interest on their underlying financing vehicles. So, there is a significant risk for the lender at the corporate level to control their cost of capital. The easiest way for a lender to reduce this risk is to be able to pass the cost on to the borrower through floating rate loans, but as we discussed above, many borrowers today are looking for fixed rate financing to lock in rates long term. Many non-bank lenders mitigate the risk of interest rate changes in short term liabilities by disposing of assets through regular loan sales or securitizations. Other mitigation strategies may include higher initial interest rates to borrowers that provide a spread between the lenders cost of capital and the interest rate charged to the borrower. Therefore, you see wide spreads between interest rates offered by banks versus non-bank lenders. Banks have a much cheaper cost of capital in that they are lending depositors money and paying little to no interest on the deposits (next time look at how much you are making on your interest bearing bank accounts).
Small balance commercial loans are typically considered illiquid, so lenders need a clear strategy to offset this risk. For alternative lenders (i.e. non-bank lenders), this can be offset through diversification of the loan portfolio (if the lender’s strategy is to hold loans till maturity) or portfolio loan sales or securitizations. For banks, their goal should be to increase its deposit base to maintain sufficient capital, as they typically are holding their loans through maturity.
Lenders are governed by statutes and regulations, and failure to comply with can result in significant financial penalties and worse. Many lenders have compliance departments just to mitigate the risk inherently associated with the lending business.
This is the risk associated with the lending operation at a corporate level and encompasses all the other risk factors combined. Bank and non-bank lenders need to maintain a clear strategy to manage the risks associated with a lending operation. Many lending regulators require a business plan from a lender that addresses how an organization will address each of these risks a plan of action.
The reputation of a lender is paramount in its ability to survive as a company. This risk is high with lenders that are not well capitalized and fail to close on approved loans.
Brokers need to be cognizant that external factors impact a lenders decision on each new loan origination. Understanding how a commercial lender thinks and underwrites a particular type of transaction will allow you to confidently place that loan with the right lender.
Lenders do not appreciate brokers that throw deals against a wall to see what works. Take the time to speak with a account executive to get an understanding of where their heads at in regards to risk on different types of transactions. In the long run this will save you time and make you money faster.
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