Stress Testing Commercial Mortgages
Much press has recently been devoted to new rules around residential mortgage lending in Canada. One of the much discussed issues has been the use of a benchmark rate. This is a qualifying rate, higher than the contractual rate. Why? Simply put, the likelihood of higher mortgage rates is significant. The Ministry of Finance has put in place new rules governing those borrowers wishing to access short term or variable rate financing, on an insured basis. Borrowers wishing insured mortgages will need to qualify at the Bank of Canada’s fixed posted 5 year mortgage rate. The Lender will thus have the added comfort that the borrower will be able to handle higher future payments resulting from potential rate increases.
Do these rules apply to Commercial Mortgage Lenders?
Are lenders stress testing commercial mortgages, and if so, are similar rules in place? Not directly similar to the mandated stress testing referenced above, but more sophisticated institutional lenders have long been stress testing their portfolios. Using tools that assess credit deterioration, pricing risk, industry exposures and overall portfolio performance, blocks of loans can be risk rated. Lenders often consider “What If” scenarios as well. Should real estate values decline by 20% across the board, what proportion of loans would be at risk? This would be of increased concern to a lender just new to commercial lending, or perhaps one that has done a significant amount of business in the recent past. Loan amortization, in such situations, would be minimal, and the portfolio would lack “seasoning” which could weather a market downturn.
Individual Loan Reviews
But what about individual loans? Most institutional lenders undertake annual loan reviews, either on a portfolio wide basis, or on some select sampling basis. An example may be all loans granted in a particular geographic area, or on a particular asset class. Perhaps they are loans exceeding a loan to value of 65% as at the date of approval. Any number of other considerations can be taken into account, including when the loan was last reviewed.
Stress testing is also making its way into the loan approval process at the time of initial underwriting. Approving a loan which has a higher probability of default, may be an approved strategy for a lender, but they would want to ensure that they understood the likelihood of future problems, and price the risk accordingly.
Prudent underwriting procedures allow a lender to consider debt service ratios, and loan-to-value ratios. However, by their very nature, they are static measures, at a snapshot in time. Stress testing at loan approval now often entails consideration of lease roll-over risk. Precisely what effect will the maturing of existing leases have to anticipated property cash flows? Will tenants renew their leases, and if so, at greater or lesser rents. If they do not renew, how long can the space reasonably be expected to be vacant, and hence a carrying cost for the owner?
Break-even Rents and Rates
Lenders also consider both break-even rents and break-even rates. A building may be leased to a variety of tenants, generating a net operating income sufficient to provide a 1.25 times debt service coverage. That is, there is $1.25 of income available to service every $1.00 of debt. But should rents fall, this ratio will diminish. The point at which the ratio is 1:1 is the level of break-even rent. Rents below this level will be insufficient to service the debt, and the borrower will need to supplement via other sources.
The corollary to this measure, is the break-even rate. Just as rents can fall, rates can rise. The rate at which the available income can just service the debt, without any surplus, is the break-even rate. A variable rate loan, or loan which is repricing at this higher break-even rate, will at a minimum consequently require additional security or a principal reduction.
Stress testing is part of the toolkit of the sophisticated lender. Understand your lender’s terminology as well as their risk assessment procedures. This can go a long way to ensuring that you and your lender are both on the same page. Present your loan proposal with confidence!