Real Estate Lending Risk. It’s a fact of life for lenders.
For an objective view on how lenders are addressing this issue, we are joined today by Larry Davies, President & CEO of Miclaur Enterprises Inc. Larry is a recognized commercial business expert, and a respected advisor to the Credit Union industry in Canada. He has a considerable amount of experience assessing risk at the institutional level.
YPLP: Larry, insofar as commercial real estate lending is concerned, are there any general themes emerging from your years of assessing lender’s portfolios? Are lenders any better at recognizing and mitigating real estate lending risk?
LD: There have been some positive developments in underwriting over the past several years, as we continue to experience a historically low interest rate environment and a steady upward trend in property values, particularly in some large urban markets. Best practice lenders now include formal stress testing to determine the impact on their risk in the event adverse trends develop. For instance, they will calculate the impact on new and renewing mortgages of things like interest rate increases, increased vacancy rates, shorter amortizations, the loss of an anchor tenant or material drop in property values.
YPLP: Prudent lenders typically set aside a provision for loss, for both individual problem loans, and also for their loan portfolios as a whole. With increased use of technology, and the availability of aggregated data, are lenders getting a better handle on portfolio risk?
LD: Partially as a result of introduction of IFRS (International Financial Reporting Standards), the calculation of loan loss provisions has become more scientific and more consistent. A specific example would be the requirement to initiate a fresh appraisal in the event of delinquency or default conditions, in order to more appropriately determine whether a reserve is required and if so, how much. For general provisions on the overall portfolio, a more robust process now exists.
YPLP: For years, real estate lenders were taught about the 3 C’s of lending, namely Character, Capital, & Capacity. I presume lending fundamentals still apply?
LD: Those fundamentals are certainly still followed by prudent lenders but the tools to measure those criteria have improved. Packaged financial analysis tools are available to allow a wider range of financial factors to be tracked and measured. There is also a higher emphasis in real estate deals on things like environmental scans, feasibility studies and more detailed appraisals, completed from multiple perspectives. There is also a higher emphasis on ownership continuity, through review of succession plans for the beneficial owner.
YPLP: In today’s low interest rate environment, lenders see considerable pressure on spreads, and consequently on their lending profits. In the hunt for increased yield, are lenders skirting with increased risk?
LD: There is clearly a very competitive environment out there right now, particularly at the lower end of the risk curve. Good lenders, though, still stick to the fundamentals of sound underwriting and will not compete on price alone. With lower spreads available in fact, lenders with a higher risk tolerance have a more difficult time competing, given the minimal wiggle room available.
YPLP: Some would argue that real estate fundamentals are changing, and we are perhaps witnessing that in retail real estate most notably. Is this evident from your experience?
LD: I have seen minimal evidence of this, although some lenders have tended to allow higher loans to value on multi-unit residential deals; in some cases going to an 80% LTV to make a deal happen. We have also seen a surge in strip mall development, while major malls have begun to see higher vacancies as a number of chain retailers have failed over the past several years. That is a dynamic that gives me some concern.
YPLP: You are familiar with the real estate credit granting processes of individual financial institutions and the industry in aggregate. From your perspective, how can prospective borrowers set themselves up for success when applying for credit?
LD: That aspect has not really changed, other than the proliferation of on-line/electronic tools to assist in formulating business plans, feasibility studies and financial scenario forecasting. The initial presentation continues to be the key document to enlist the aid of a lender but the business owner also needs to fully understand the details of his or her presentation when applying for credit. Regardless of the apparent strength and value of the asset being financed, the key element in business failure is and always will be poor management skills.
YPLP: Thank you for your insightful comments Larry.