PERSON OF THE WEEK: The commercial real estate (CRE) industry continues its steady growth as we move through 2019. As the number of CRE projects increases, so too does the demand for the loans to fund them, and many financial institutions and non-bank lenders are turning to this space seeking opportunities to grow their business. However, CRE lenders face some major issues and obstacles that have the potential to severely limit their ability to close deals and gain new business.
With rising competition from both traditional financial institutions and newer non-banks and fintechs, today’s CRE lenders need every advantage and that may mean considering a new approach to one of the industry’s standard, yet outdated, practices – the personal guarantee requirements for borrowers.
David Eichenblatt, president and founder of LGIS Group (LGIS), recently discussed some of the challenges facing today’s CRE lenders, and how adopting a more modern strategy in CRE loan underwriting can both lower the costs associated with borrowing and give lenders the tools to succeed with a competitive advantage to grow in the marketplace.
Q: What are the key issues facing commercial real estate (CRE) lenders when it comes to gaining market share?
Eichenblatt: While today’s CRE lenders face many challenges, there are three that are critical especially when growing their overall business. The first is increased competition. In today’s market, there seems to more – almost an excess – of liquidity available. Because of this, financial institutions are now increasingly facing more and more competition, not just from other banks and credit unions, but also from the influx of non-banks, fintechs and other alternative lenders now entering the industry. What’s more, these new types of lenders are not always held to the same regulatory oversight and scrutiny which can affect their costs and thus their offerings.
The second issue is the tightening margins for CRE lenders. While increased competition has led to some better deals for borrowers and opened the door for some new industry ideas, it has also inevitably created thinner spreads for all lenders, lowering overall profits for each deal and negatively affecting their credit, as well.
The final key issue CRE lenders are facing is one of the hardest to overcome, and that’s dealing with outdated methods and approaches. Following “traditional” methodology can sometimes stifle innovation and this is the unfortunate case with CRE lending.
To put it in perspective, there has been very little – if any – change in the way today’s banks make loans since the time of the Medici (particularly post Great Recession). While almost all other aspects of banking are experiencing steady innovation, CRE lending seems to be standing in place.
Today’s lenders must update their methods, especially in how they assess and manage loan risk related to credit. One good option is to look towards another industry – insurance. For example, while most financial institutions are very good at accumulating and distributing capital, it is insurance companies that are best at assessing and managing risk. Those financial institutions that can adapt, adopting a loan review process that doesn’t rely on outdated, less reliable forms of addressing credit primarily based on personal guarantees, could realize a big increase in their reach and overall number of deals.
With many non-banks filling this exact gap today, perhaps financial institutions should not be giving up this territory so easily. Financial institutions recognizing the need for change in other areas of banking is what successfully brought in new tools such as PMI for residential loans and SBA for business loans.
Q: CRE lenders have traditionally required a personal guarantee from borrowers to help hold their “feet to the fire” in case of trouble. How effective is this at actually protecting the lender’s interest?
Eichenblatt: Not only are personal guarantees extremely ineffective at protecting CRE lenders when it comes to recouping losses should a loan default, they can even be detrimental. Unfortunately, the concept of a personal guarantee strengthening a loan is an old myth embedded in the industry. Even worse, this method is a proven adversarial approach, especially from a customer relationship (and full collection) standpoint. When a CRE lender threatens its borrowers and sponsors with personal ruin, it motivates them to protect their self-interest rather than focusing on solving a project’s problem.
Most lenders openly admit they rarely if ever collect on a personal guarantee. What’s more, borrowers often have the leverage to negotiate a discounted payoff (DPO), which can drag out the collection process, ultimately running up the total costs for the lender while lowering what they would receive.
By not threatening the borrower/sponsor with personal ruin, the lender creates a much more cooperative approach to solving a problem. An insurance solution, like commercial property loan insurance (CPLI), gives both the lender and sponsor the piece of mind they will be protected in the event of a worst-case scenario.
What’s more, this opens the possibility of additional equity being invested in certain situations while benefiting all parties by saving valuable time and money slogging through legal proceedings.
To put this in perspective, the borrower/sponsor – the party running the business associated with the CRE project – invests very little of the project’s equity, roughly 10 percent or less, while a partner, a passive investor, is responsible for the remaining bulk. Thus, it is the investor, rather than the lender, that will have far greater leverage over the borrower/sponsor to keep their “feet to the fire” as this partnership is much more entrenched.
Q: Despite reports showing increased CRE lending activity over the last year, some trends suggest there will be an inevitable downturn in the CRE market in the near future. Should lenders be worried?
Eichenblatt: I agree with many of the industry experts that the signs are becoming increasingly clear we are approaching an “end of cycle risk” in CRE lending, especially with the projected slow-down of the overall economy. However, at the same time, there has also been some very strong discipline in the industry over the past few years, with little to no over-building or “loose” money – all positive signs going into this possible downturn.
Many CRE lenders are also becoming slightly more conservative in their underwriting as they prepare for these near-future events. Those taking this approach have much less to fear and are definitely in a better position to weather any storms.
Q: By adopting a CPLI strategy, what affects could this have on a CRE lender’s overall relationship with its customer?
Eichenblatt: Bottom-line, leveraging CPLI as a component of a CRE portfolio strategy offers lenders an excellent resource from a customer service perspective, and can reinforce, enhance and even expand those relationships. As mentioned, personal guarantees are a contentious topic right from the beginning when negotiating a CRE loan. What’s worse, they will also be what likely terminates a relationship between the borrower and lender upon a default and foreclosure. Removing this contention paves the way for a richer, more trusted relationship between the two.
What’s more, doing so offers the lender a strong competitive advantage as they likely will be positioned to extend borrowers lower rates on their loans and perhaps may even find additional available investment capital. With the standard, traditional liquidity and net worth covenants no longer a key issue, these borrowers could find themselves willing and able to pursue additional projects with a lender, giving the financial institution the opportunity to close more deals with the same customer. Ultimately, this can lead to more deposits, cross-selling opportunities, and most importantly, the fostering of a deeper, more holistic relationship with the customer.
Q: Current capital reserve regulations limit the capacity for increased CRE lending, and potential borrowers are limited by their own balance sheet – how can lenders overcome this hurdle?
Eichenblatt: When calculating its reserves, a CRE lender must estimate a loss given default (LGD) and probability of default (PD) for each loan. While a solution like CPLI offers lenders an improvement for a loan’s PD estimate, they can realize significant gains in their loans’ LGD. By greatly reducing the reserve requirements for CRE loans, an insurance solution such as CPLI can create an increased capacity for more loans and thus, an increased opportunity for more long-term profit.
While the capital relief provided by CPLI for lowering a lender’s reserve is important in itself, it also has the added benefit of removing the possibility of a loan being classified as High Volatility Commercial Real Estate, which adds increased risk weighting and consequently more unproductive tier one core reserves being required. Having the ability to redeploy these reserve funds into other loans within the financial institution offers a significant return on equity for the lender and increases both its success and overall valuation. What’s more, the lender could instead use this to lower its rates, sharing some of this gain with the borrower and further enhance the relationship as well as its competitive advantage.