LOAN PORTFOLIO MANAGEMENT - YEAR 2

Transcription

1 LOAN PORTFOLIO MANAGEMENT - YEAR 2 Commercial Real Estate Loan Portfolio Risk Management Mike Hendren Real Estate Senior Credit Officer Pinnacle Financial Partners Nashville, TN mike.hendren@pnfp.com July 31, 2018

2 Graduate School of Banking Commercial Real Estate Loan Portfolio Risk Management 2018 Mike Hendren Nashville, Tennessee

3 DISCLAIMER Comments and materials contained herein are those of the presenter and do not necessarily reflect the opinions, policies or practices of Pinnacle Financial Partners, Inc. or its affiliates and subsidiaries. The presenter is solely responsible for content and comments. 2

4 I ain t here for a long time. I m here for a good time. - George Strait 3

5 Oh boy, is this great! - Kent Dorfman

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7 Portfolio Management? Yeah, right. (Is it in my incentive plan?) 6

8 My Objective Today 7

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10 Commercial Real Estate The Quest For Net Operating Income NET OPERATING INCOME IS: GROSS POTENTIAL RENT LESS: VACANCY EQUALS: EFFECTIVE GROSS RENT PLUS: MISCELLANEOUS INCOME EQUALS: EFFECTIVE GROSS INCOME LESS: OPERATING EXPENSES EQUALS: NET OPERATING INCOME -- OR -- CASH FLOW BEFORE: Income Taxes Depreciation Interest Expense Principal Amortization NET OPERATING INCOME DETERMINES: Value Leverage Capacity 9

11 In fact, buildings are essentially boxes that hold the economy. Craig Thomas Torto Wheaton Research 10

12 Did we need more boxes? At the end of 2009, the average U. S. resident s net worth - the market value of property and investments minus mortgage, credit card and other debts - stood at $175,600 according to data from the Fed and the Commerce Department. In inflation adjusted terms, that s up 5.7% from the end of 2008, but still well below the peek of $218,650 in the second quarter of Wall Street Journal From December 2008 to December 2009 employment declined in 325 of the 334 largest U. S. Counties. Total non-farm payroll employment decreased by 125,000 in June 2010 reflecting the departure of 225,000 temporary census 2010 workers from federal government payrolls. Total private employment edged up by 83,000 over the month due to modest increases in several industries. So far this year, private sector employment has increased by 593,000 but in June was 7.9 million below its December 200 peek. - U. S. Bureau of Labor Statistics BY COMPARISON million square feet of office space were delivered nationally in 2008 and ,440 apartment units were delivered nationally in 2008 and million square feet of retail space were delivered nationally in 2008 and million square feet of industrial space were delivered nationally in 2008 and Reis 11

13 So, where are we? 12

14 What Inning Are We In? (This is the class participation part of the program because I don t know.) 13

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16 It s Getting Late! Investors deciding where to buy, hold or lend on assets at this point in the cycle should be doing so knowing that it is increasingly possible that the hold period could cross paths with an economic downturn. CoStar s Probability of Recession model indicates a 50%-plus cumulative chance of the nation going into a recession by the end of CoStar: Market Selection With A Downturn In Mind May 31,

17 IT S THE ECONOMY, STUPID! The level of credit risk in most banks is inextricably linked to the business and economic cycle. Because the U. S. economy has been healthy for the past several years, it is not surprising that many banks recently have enjoyed record high levels of earnings and capital. Nonetheless, banks must be prepared for any future deterioration in economic conditions. Most problem credits are the result of lending decisions and assumptions of credit risk that were made during periods of general strength in the economy. Jimmy Barton Chief National Bank Examiner March 11,

18 BAD LOANS ARE MADE IN GOOD TIMES 17

19 Red Light / Green Light Construction Term Office Warehouse Hotels Apartments Retail: Anchored Strip Center Retail: Unanchored Strip Center Retail: Single-Tenant Self-Storage Medical Office Loans To Rich People 18

20 Despite our favorable view of recent loan growth, as the economy recovers history suggests that underwriting standards will deteriorate, Moody s analyst wrote in their most recent weekly credit markets report. Already, a number of banks mentioned in their recent quarterly earnings teleconferences that loan pricing competition has increased. Our experience has been that after affecting price, competition typically weakens loan structures and covenants. Once that occurs, it will translate into asset quality problems down the road. Therefore, a leading indicator for banks asset quality will be the pace of their loan growth relative to overall economic growth. Banks Finally Willing To Catch Up on CRE Borrowing Demand CoStar Realty Information, Inc. 5/16/

21 Hey you, knock it off! I m talking to you. Underwriting among national banks and federal savings associations eased for the third consecutive year, according to a reported released today by the Office of the Comptroller of the Currency (OCC). We re seeing trends very similar to those that examiners reported just prior to the most recent financial crisis, said Jennifer C. Kelly, Senior Deputy Comptroller and Chief National Bank Examiner. With credit risk on the rise, OCC examiners will remain focused on evaluating new loan originations to assess banks and federal savings associations efforts to main prudent underwriting stands and practices through this state of the credit cycle. In the survey, examiners noted that banks and federal savings associations have eased underwriting standards and increased levels of credit risk in response to competitive pressures and abundant market liquidity. Underwriting Standards Continue to Ease, OCC Survey Shows December 9,

22 Interagency Guidance: Statement on Prudent Risk Management for Commercial Real Estate Lending The agencies examination and industry outreach activities have revealed an easing of CRE underwriting standards, including lessrestrictive loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements. The agencies also have observed certain risk management practices at some institutions that cause concern, including a great number of underwriting policy exceptions and insufficient monitoring of market conditions to assess the risk associated with these concentrations. 21

23 Interagency Guidance: Statement on Prudent Risk Management for Commercial Real Estate Lending During 2016, supervisors from the banking agencies will continue to pay special attention to potential risks associated with CRE lending. When conducting examinations that include a review of CRE lending activities, the agencies will focus on financial institutions implementation of the prudent principals in the Concentration Guidance as well as other applicable guidance relative to identifying, measuring, monitoring and management concentration risk in CRE lending activities. In particular, the agencies will focus on those financial institutions that have recently experienced, or whose lending strategy plans for, substantial growth in CRE lending activity, or that operate in markets or loan segments with increasing growth or risk fundamentals. The agencies may ask financial institutions found to have inadequate risk management practices and capital strategies to develop a plan to identify, measure, monitor and manage CRE concentrations, to reduce risk tolerances in their underwriting standards, or to raise additional capital to mitigate the risk associated with their CRE strategies or exposure. 22

24 Interagency Guidance: Statement on Prudent Risk Management for Commercial Real Estate Lending In general, financial institutions that succeeded during difficult economic cycles took the following actions, which are consistent with supervisory guidelines: Established adequate and appropriate: Loan policies, underwriting standards, credit risk management practices, and concentration limits that were approved by the board or a designated committee; Lending strategies, such as plans to increase lending in a particular market or property type, limits for credit and other asset concentrations, and processes for assessing whether lending strategies and policies continued to be appropriate in light of changing market conditions; and Strategies to ensure capital adequacy and allowance for loan losses that support an institution s lending strategy and were consistent with the level and nature of inherent risk in the CRE portfolio. 23

25 Interagency Guidance: Statement on Prudent Risk Management for Commercial Real Estate Lending -- Conducted global cash flow analyses based on reasonable (not speculative) rental ratesn sales projections, and operating expenses to ensure the borrower has sufficient repayment capacity to service all obligations. -- Performed market and scenario analyses of their CRE loan portfolio to quantify the potential impact of changing economic conditions on asset quality, earnings and capital. -- Provided their boards and management with information to assess whether the lending strategy and policies continued to be appropriate in light of changes in market conditions. -- Assessed the ongoing ability of the borrower and the project to service all debt as loans converted from interest-only to amortizing payments or during periods of rising interest rates. -- Implemented procedures to monitor the potential volatility in the supply and demand for lots, retail and office space, and multi-family units during business cycles. 24

26 Interagency Guidance: Statement on Prudent Risk Management for Commercial Real Estate Lending -- Maintained management information systems that provided the board and management with sufficient information to identify, measure, monitor and manage concentration risk. -- Implemented processes for reviewing appraisal reports for sufficient information to support an appropriate market value conclusion based on reasonable market rental rates, absorption periods and expenses. 25

27 Global Cash Flow Example Borrower Lawsonia LLC Uh Oh LLC Ginsburg II LLC Spec Inc. Totals / Global Property Name Lawsonia Links The Uncommons Walgreens Stinking Creek Rd. Property Type Apartments Office Retail Land % Ownership 50% 100% 50% 100% Appraised Value $5,200,000 $1,750,000 $4,000,000 $1,750,000 $12,700,000 Appraisal Date 7/1/2007 8/15/2008 9/1/2009 3/12/2010 Debt $2,918,529 $1,325,000 $3,000,000 $1,312,500 $8,556,029 Lender Bogey Bank Bogus Bank Bank of GSB Bad Bank Maturity 7/17/2014 8/15/ /1/2016 3/15/2013 Net Operating Income $405,612 $98,750 $310,000 $0 $814,362 Annual Debt Service $270,999 $112,678 $237,480 $65,825 $686,982 Debt Service Coverage % Net Cash Flow $67,307 ($13,928) $36,260 ($65,825) $23,814 % Equity $1,140,736 $425,000 $500,000 $437,500 $2,503,236 Contingent Liability $2,918,529 $1,325,000 $3,000,000 $1,750,000 $8,993,529 26

28 Project and Sponsor Global DSC Roll-Up LOANS OVER $500,000 SECURED BY APARTMENTS PROJECT AND GLOBAL DEBT SERVICE COVERAGE ROLL UP Outstanding Project Sponsor Loan No. Borrower Loan Balance DSC Global DSC Lawsonia Links Apts. LLC $2,918, Erin Hills, LLC $1,752, Blue Mound Lofts LLC $976, Whistling Straits Landings LLC $2,478, University Ridge, LLC $2,145, TOTAL / WEIGHTED AVERAGE $10,270,

29 Guaranties 28

30 The Prevailing Underwriting Trade-Off $1 Equity = $ Guaranty or $1 Equity = $ Guarantor Liquidity 29

31 What s the Main Thing: Rank the importance of the following underwriting criteria: Project Loan-To-Value Ratio Project Debt Service Coverage Ratio Borrower/Guarantor Liquidity Borrower/Guarantor Global Cash Flow Tenant Turnover During Primary Loan Term Pre-Leasing Percentage Vulnerability of Ratios to Stress Testing 30

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37 Credit Underwriting and Administration An institution s lending policies should permit only limited exceptions to underwriting standards. Robust risk management systems can also track the number of exceptions by type and amount. vs. If you ain t cheating, you ain t trying. 36

38 Too much of a good thing is a good thing. - Alan Jackson Construction and development loans were by far the worst performers in the crisis, and concentrations in C&D proved to be a reliable indicator of the likelihood of failure for both national and state community banks. In March of 2007, nearly 2,000 of these banks held C&D loans that exceeded their capital. By September of last year, 13 percent of them had failed. If you expand the view to look at excessive real estate lending, look through the lens of the real estate guidance the regulatory agencies jointly issued in That guidance set thresholds of 100 percent of capital for construction lending and 300 percent of capital for total CRE. Where banks were in excess of those concentration thresholds, 23 percent failed. Where banks were within those thresholds only about one-half of one percent failed. Thomas J. Curry Comptroller of the Currency June 13,

39 23% vs. 0.5% 38

40 Portfolio Management: Slice & Dice 39

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43 Can You Produce This Graph? 42

44 What about this one? 43

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46 You will be wrong. How wrong can you afford to be? Stress Each Loan For: 1.Interest Rate Sensitivity (DSC) 2.Vacancy Rate Sensitivity (DSC & LTV) 3.Capitalization Rate Sensitivity (LTV) TEST 80% OF THE CRE LOAN BOOK 45

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48 Will Cap Rates Decompress? Investors have been wondering how an increase in interest rates will affect capitalization rates on commercial real estate assets.of course, capitalization rates are determined by much more than just the yields on government treasuries. Our research shows that cap rates are also driven by the term structure of interest rates, the overall risk premium demanded by investors and the economy-wide availability of credit, along with local real estate fundamentals such as rent levels and their position relative to the long-term trend. Projected cap rate increases will be gradual and not large. This results from the fact that cap rates are determined by much more than just interests rates: all the factors mentioned above such as debt availability, real estate fundamentals and risk appetite are very important. Under our forecast of continued economic recover, these other factors will partially offset the negative impact of an interest rate increase and will moderate the resulting jump in cap rates. Also, the cap rate spreads to Treasury s are currently at historic highs and will compress as cap rates increase by much less than the underlying 10-year Treasury yields. - What Will Happen To Cap Rates When Interest Rates Increase? CBRE Econometric Advisors June 24,

49 Source: Commercial Property Outlook in a Rising Rate Environment Ernst & Young LLP September

50 Source: Commercial Property Outlook in a Rising Rate Environment Ernst & Young LLP September

51 Source: Commercial Property Outlook in a Rising Rate Environment Ernst & Young LLP September

52 LOANS OVER $500,000 SECURED BY APARTMENTS DEBT SERVICE COVERAGE STRESS TEST RESULTS CHANGES IN VACANCY ACTUAL VACANCY PLUS 5%, 10% & 15% Outstanding Actual Add 5% Add 10% Add 15% Loan No. Borrower Loan Balance DSC DSC DSC DSC Lawsonia Links Apts. LLC $ 2,918, Erin Hills, LLC $ 1,752, Blue Mound Lofts LLC $ 976, Whistling Straits Landings LLC $ 2,478, University Ridge, LLC $ 2,145, TOTAL / WEIGHTED AVERAGE $ 10,270, LOANS OVER $500,000 SECURED BY APARTMENTS DEBT SERVICE COVERAGE STRESS TEST RESULTS CHANGES IN INTERESET RATE ACTUAL INTEREST PLUS 100 BASIS POINTS INCREMENTS Outstanding Actual Add 1.0% Add 2.0% Add 3.0% Loan No. Borrower Loan Balance DSC DSC DSC DSC Lawsonia Links Apts. LLC $2,918, Erin Hills, LLC $1,752, Blue Mound Lofts LLC $976, Whistling Straits Landings LLC $2,478, University Ridge, LLC $2,145, TOTAL / WEIGHTED AVERAGE $10,270,

53 LOANS OVER $500,000 SECURED BY APARTMENTS LOAN TO VALUE STRESS TEST RESULTS CHANGES IN CAPITALIZATION RATES PREVAILING CAP RATES PLUS 100 BASIS POINTS INCREMENTS Outstanding Actual Add 1.0% Add 2.0% Add 3.0% Loan No. Borrower Loan Balance LTV LTV LTV LTV Lawsonia Links Apts. LLC $2,918, % 63.0% 70.0% 77.0% Erin Hills, LLC $1,752, % 83.0% 90.0% 93.0% Blue Mound Lofts LLC $976, % 79.0% 87.0% 95.0% Whistling Straits Landings LLC $2,478, % 89.0% 96.0% 103.0% University Ridge, LLC $2,145, % 84.0% 90.0% 96.0% TOTAL / WEIGHTED AVERAGE $10,270, % 78.6% 85.5% 91.7% 52

54 Debt Yield An Excellent Litmus Test PROPERTY NOI / LOAN AMOUNT Recommended Benchmark: 10% 53

55 Starting Today: Be more discriminating in terms of client selection, project quality, project location, supply constraints (barriers to entry), lease terms, tenant creditworthiness and shifting demographics. 54

56 Remember: If we do not discipline ourselves today, the world will do it for us. - William A. Feather 55

57 Remain calm all is well! 56