By Nick Reynolds, VP/Credit Services Manager
The risks associated with business lending differ significantly from those associated with traditional consumer lending. While consumer information is still an important part of knowing your member, the types of risks associated with commercial loans tend to be more varied and wider in scope. This article is one in a series to help credit unions more clearly understand some of the unique risks of business lending.
If you are a fan of the 1993 Steven Spielberg movie Jurassic Park, you may recall the memorable words of Dr. Ian Malcolm (as played by Jeff Goldblum): “Your scientists were so preoccupied with whether or not they could that they didn’t stop to think if they should.”
So it goes with real estate lending. Huge swings in commercial and multi-family real estate valuations since the financial crisis have rightfully given lenders pause (Fig. 1). Historically, the NCUA has authorized credit unions to lend up to a maximum 80% advance rate on commercial real estate. Recent changes to NCUA’s regulations have removed this prescriptive limit, but it still begs the question of whether you should consider going to 80% loan-to-value (LTV), or even higher, on a particular request.
One question I often receive is: Why is an 80% LTV ratio considered the industry standard for determining adequate collateral coverage? One way to look at this is that 80% represents the breakeven ratio on a typical commercial property, if it goes to foreclosure. You can estimate approximately 10% of property value will be spent on costs associated with the foreclosure process, including legal expense, carrying costs, any needed property repairs, and professional management. Once you factor in the realtor’s commission and any discount the buyer negotiates because it is a foreclosure, total costs may easily reach 20% of property value.
There are a number of factors you should consider when you look at a real estate property. In order to be competitive with other lenders, you often will need to advance 80% to win a deal. Under many circumstances, this will be fine. But you need to consider a few important aspects before approving the loan.
One key factor is the reliability of the appraisal. A real estate appraisal should include several “comparables” or “comps”—nearby properties that are similar in use, condition, and size to the subject property. The more closely these comps resemble your collateral, the greater your confidence will be in its appraised value. One home among a thousand of similar homes, with close, recent comps, will provide you with a high degree of confidence. On the other hand, your level of confidence will be much lower on a property with no local comps or recent nearby sales. After all, an appraisal is simply an educated opinion of value. Some of those opinions are supported better than others. You should take into account the levels of confidence and potential variability in the value in your advance rate.
Similarly, some properties are inherently more marketable. For example, an apartment building, a tilt up concrete warehouse with office space, and many types of retail locations are of general interest and the pools of potential buyers are large. But certain special-use properties don’t offer that same level of general appeal. Such properties include bowling alleys, car washes, gas stations and convenience stores, hotels, water parks, golf courses, and movie theaters. If the property only serves a single best use, you should consider a lower advance rate, because the pool of potential buyers is quite limited. Combined with the fact that, in a foreclosure scenario, the likelihood is high that local market conditions may not support that type of business in that specific location, you are going into a sale at a disadvantage.
There are other factors that may adversely impact the salability of your collateral. Rural locations often have a more limited market, and a lower advance rate is often warranted. The quality of leases and tenants may also impact the value. If the borrower holds a long term lease to a single tenant, the performance of that tenant has an outsized influence on property cash flows, and you may wish to reduce your advance rate. Also, if the current leases are below the market rate the appraiser used, you would want to reduce the advance rate.
Lastly, make sure to consider local economic and business conditions. Some markets, including major metropolitan areas and popular tourist destinations, tend to see much greater volatility in real estate prices than other, more stable areas. If you lend in an area that sees such high fluctuations in property values, consider using a lower standard advance rate than 80%.
Remember that your personal familiarity with your borrower and the local market are major advantages and should factor strongly in your underwriting decisions.
