LOAN RISK MANAGEMENT DURING A DOWNTURN: A CALCULATED SCIENCE
Part of our job here at Extensia Financial—a very significant part—is to help our partners navigate the complex matter of risk management. This is one of the many functions a credit union service organization (CUSO) performs. In the midst of the current public health and economic crisis, we are fielding quite a few calls pertaining to the lack of property rental income. These calls are actually a good sign because both our Borrower and credit union customers are engaging in an early dialogue with us and keeping the lines of communication open. This is when we can help the most. When we look at data, trends, and options together, risk management can be much more proactive than reactive.
History is on Our Side
It is not just the pre-funding loan aspect that the CUSO monitors for risk mitigation; Extensia also thoroughly reviews, assesses and mitigates post-funding risk whenever possible. Extensia has underwritten over $3.5 billion of commercial real estate loans spanning 42 states. Together, the executive staff at Extensia has approximately 50 years of experience helping Lenders manage and mitigate risk. Across our company, Extensia’s typical staff member has about 8 years of tenure, and the vast majority of our team members came to us with prior real estate and/or lending experience.
Extensia is a full-service commercial real estate CUSO that originates, documents, underwrites, processes, and coordinates funding between Lenders and Borrowers. And once a loan has closed, we service the loan for its entire life, including special collections and foreclosure if necessary. Extensia has years of experience tracking the covenants that protect lenders, collecting loan payments, and working with Borrowers. Extensia provides local credit unions the ability to participate in larger commercial projects, often beyond the scope of their geographic area, field of membership, typical asset classes or loan size. Our relationships with our credit union partners allow us to source loan opportunities that best fit the credit union’s lending strategy because we take the time to listen to each of our customers and work with them to understand the lending plan they want to put in place.
What’s Happening Today?
In the past few months, since the pandemic hit our shores, Extensia has received and processed a number of Borrower requests for payment forbearance due to the effects of COVID-19. While precautions vary from region to region and state to state, many commercial real estate properties not deemed “essential” have been required to temporarily close by public health mandate. Additionally, with the tremendous number of people that are unemployed, multi-family properties have also been, and continue to be, impacted. Suddenly, property cash flow and, in turn, loan payments are being affected, as are the lenders that financed these properties.
To offset the economic impact of the pandemic, the Federal Reserve has lowered its lending rate for banks to 0%. Many people mistakenly assume that the Fed’s new, lower interest rate immediately translates to lower interest rates for the consumer; however, consumers typically will not see that interest-rate drop extend to main street in the near term.
Many commercial mortgage-backed security (CMBS) lenders have already paused issuing new commercial real estate loans until they determine the short and intermediate-term effects of COVID-19. Fannie and Freddie have also temporarily pulled back from funding new multi-family loans. Simultaneously, multi-family and commercial lenders are inundated with requests for lower interest rate refinancing. Some banks have instituted false floors to prevent their interest rates from falling below a preset, profitable level.
Operating Statements Are Essential
When assessing property operations and the financial health of the associated Borrower, it is essential to gather two to three years, or more if possible, of operating statements. Loan Servicers, such as Extensia Financial, are working to create for the Lender a clear picture of the property, Borrower and, if applicable, guarantor’s trend line over the review period, as well as the prior two to three years. There are a number of questions we are looking to answer. Is the rental income showing an increasing trend, or has it remained relatively flat? Has the Borrower’s liquidity and net worth continued to increase? Has there been a marked change in either dimension that cannot be easily explained, e.g. the purchase of a new real estate asset? The answers to these questions are incorporated into the loan review.
As the loan servicer, Extensia verifies payment performance for regular, timely payments. The Borrower’s payment history over both the short and long-term will typically provide a high-level indicator of the Borrower’s financial health. Given the current world economy, this factor should be an area of focus for Lenders, if not already.
A loan payment history that contains late payments signals a Lender or Servicer that a more in-depth discussion or property inspection is warranted. It may indicate that a cash flow issue exists with the Borrower, which in turn can pose problems for the Lender. Because we are a CUSO servicing commercial real estate loans for the credit union industry, it is our responsibility under the National Credit Union Administration (NCUA) regulations to keep Lenders informed of their Borrowers’ loan payment history.
To Their Credit
Poor Credit Reports
As most people know, Credit ratings play a significant role in the interest rates for which a Borrower will qualify. In fact, they determine a number of factors: the degree of risk (i.e., exposure to possible default), the amount of capital to be loaned/borrowed, the interest rate, and the term associated with the loan. While favorable credit reports typically translate into lower risk and, therefore, lower rates, weak credit reports usually translate into higher risk and higher rates.
The Three C’s of Credit – Character, Capital, and Capacity
Credit scores are dynamic. They can change either positively or negatively depending on the amount of debt incurred and how timely bills are paid. Lenders look at a Borrower’s character as indicated by how they have handled debt and payments in the past. By looking at a Borrower’s credit history and personal background, Lenders can determine a Borrower’s integrity and reliability, and, thus, their likelihood to pay their bills. Capital refers to current assets available to the Borrower, such as savings, investments, and real estate that could be used to repay debt, if necessary. Capacity addresses how much debt a Borrower can comfortably handle. To determine capacity, income streams and borrowing obligations are assessed to determine the amount of liability that would be considered reasonable for the Borrower to take upon themselves.
A good loan Servicer recognizes that credit reports function not only as an early indicator of risk exposure at the origination of a loan but also as an on-going benchmark during the loan tenure. By keeping apprised of the Borrower’s credit scores, the Servicer is often able to identify and address any concerning indicators before a greater problem comes to light. Extensia reviews each loan it services annually to determine the trend line of each loan. Our Asset Managers typically create a 3-year operating history comparison, if available, to determine whether a loan is holding steady, improving, or declining. We also review each entity’s date-to-date operating results, liquidity and net worth. These data-points are incorporated into the analysis, along with credit scores, when creating a loan review. Equipped with the information gained from all the data compiled in the loan review, Extensia is able to tailor a plan for that specific loan.
Global Cash Flow
Global Cash Flow refers to the amount of income (or cash) that is generated across a Borrower’s entire real estate portfolio. This calculation takes all properties with positive cash flow and subtracts any property’s operating results that are simultaneously experiencing a negative cash flow to derive the positive or negative global cash flow of that Borrower. It is essential to assess how much cash is available, globally, to pay all obligations across the entire portfolio, as ancillary or contingent liabilities can potentially affect assets with positive cash flow by requiring the cash be drained in support of weaker properties. For this reason, Servicers and/or Lenders must always consider the possible impact of one asset’s negative cash flow on the other assets within a real estate investor’s portfolio. We want Lenders to understand that, depending on the ownership structure, a Borrower’s portfolio very well may function as a whole.
Any operating statement anomalies must be vetted with the Borrower to determine if these items constitute one-time capital expenses that depreciate over time or if an underlying maintenance or management issue exists. These types of issues frequently arise in annual reviews. By assessing how global cash flow plays out across entire portfolios, we are able to work with Borrowers to mitigate risk for our credit union customers. Our objective is to keep the loan current and the risk rating as favorable as possible.
It’s All in the Math
Loan to Value (LTV) Ratio
Lenders and Servicers utilize indicators to ensure they are not lending more on a property than they reasonably should. To calculate an LTV ratio, the outstanding loan balance (LB) is divided by the present value (PV) of the property. LB/PV=LTV%.
Lenders often have differing minimum LTV requirements based on the specific type of asset or location of the property. This calculation helps the Lender and Servicer keep track of the equity in the property value to ensure that it is not eroding. If it is, then it becomes necessary for us to work with the Borrower to mitigate this erosion (risk).
Debt Service Coverage (DSCR) Ratio
Another number we look at is the Debt Service Coverage Ratio (DSCR), which measures the cash flow available to pay current debt service obligations after all property expenses are satisfied. A decrease in revenue causes a reduction in DSCR, so we keep our eye on this figure to identify trend lines, spikes, or repeating patterns. In this calculation, the higher the number, the more cash flow available to make mortgage payments. Again, as with LTV, the minimum DSCR that a Lender requires may vary depending on the asset class or property type.
All of these tools are utilized in concert to help Servicers and Lenders identify and mitigate on-going exposure to risk.