Today’s commercial real estate (CRE) industry has continued to see an upswing in growth. Despite concerns of a projected economic slow-down, the demand for CRE projects and developments has been steady, as is the demand for the loans needed to fund them. Representing a significant revenue opportunity, and once almost the sole purview of traditional banks and credit unions, these institutions are now facing competition from an influx of non-banks, fintechs and other alternative lenders entering the market. What’s more, many of these new lenders, often held to lesser oversight and regulatory scrutiny, can be more flexible in their offerings, making them attractive to potential borrowers.
With rising competition from these new players, as well as from traditional lenders, today’s banks and credit unions need every advantage to gain ground and succeed, and that means adopting a more modern strategy in their CRE lending approach.
Adapting for Today’s CRE Lending Market
With 2019’s positive financial trends, demand for capital from CRE developers continues to climb. A recent report on the U.S. market from CBRE suggests the outlook for all major CRE types remains very positive for the year even this late in the cycle, and Deloitte reports a steady rise in global CRE investments and U.S. CRE investments growing by 11 percent year-over-year to $122 billion last year.
While these projects represent a tremendous revenue opportunity for lenders, they can also present a dilemma. Because of capital reserve requirements and tighter, thinner margins from growing competition, many of today’s banks and credit unions are being forced to choose between limiting their overall CRE lending or increasing their risk exposure by loosening loan credit standards, which is not something most lenders (especially their chief credit and risk officers) wish to do.
Most lenders have no issues underwriting credit risk when it comes to residential mortgages; these loans can be mitigated with private mortgage insurance (PMI) rather than taking on all the risk against lender’s portfolio. To reduce this risk when it comes to CRE loans, financial institutions traditionally require what is known as a personal guarantee from the individual borrower or sponsors requesting the loan, placing the borrower’s personal balance sheet on the line in case of default. However, personal guarantees are at best problematic, and at worst almost completely ineffective in protecting the lender; a common reality for most, and yet, until recently, the only tool available for them.
Personal guarantees offer little protection for CRE lenders when it comes to recouping losses, with most lenders openly admitting they rarely collect on them during the default process. Unfortunately, the idea that a personal guarantee strengthens a loan is a somewhat firmly embedded industry myth. What’s more, they can even prove to be adversarial when it comes to maintaining a positive customer relationship. In addition, even with guarantee, borrowers can still leverage or often negotiate a Discounted Payoff (DPO), dragging out the collection process, increasing the costs for the lender and reducing what they may manage to collect, all with the risk of uncertainty.
Today’s banks and credit unions need an updated method for how they assess, manage and mitigate loan risk related to credit, an approach closer to the insurance industry. While most financial institutions are very good at accumulating and distributing capital, insurance companies are the ones that excel when it comes to assessing and managing risk
Banks and credit unions already recognize the need for better risk management in other areas of banking, like with PMI for residential loans and SBA for C&I loans, but have yet to do so with CRE loans. While banks and credit unions want to adapt to meet the demands of the current CRE lending market, until recently there have been few if any alternatives to reliance on the outdated personal guarantee. However, lenders now have the option of adopting a Commercial Property Loan Insurance (CPLI) strategy to better manage risk. Similar to how PMI works for residential loans, CPLI allows lenders to transfer the risk of their CRE loans, lowering exposure and even offering additional capital relief to make more loans.
Covering the top 25 to 40 percent of a qualified CRE loan amount (the riskiest portion), CPLI offers significant protection for the potential lender against losses in the event of default and with no risk of certainty. As with PMI in the residential loan market, CPLI allows banks and credit unions to underwrite and approve CRE loans without the need to include the outdated and often contentious personal guarantee that stymies the loan process.
Looking at the long term, using this approach not only provides better operational efficiency, but also greatly improves the lender’s overall risk position for their portfolio. This creates the capital relief necessary to fund and support further CRE lending, which offers exponential growth opportunities with a higher return on equity (ROE). When a CRE lender calculates its reserves, it needs to estimate both the Loss Given Default (LGD) as well as the Probability of Default (PD) for each of its loan. A CPLI strategy offers banks and credit unions an improvement for both, with the potential for significant gains in their loans’ LGD. Reducing the CRE loan reserve requirements can create that additional capacity for more loans, increasing revenue opportunities and ROE while lowering risk, helping to ease the concerns of today’s chief risk officers.
While the capital relief alone is a significant benefit, a CPLI strategy also can lower or entirely remove the chance a CRE loan will be classified as HVCRE (High Volatility Commercial Real Estate). HVCRE loans have much higher risk weighting, requiring even more ineffectual Tier One Core reserves for the lender. By removing this risk and giving banks and credit unions the ability to leverage these reserve funds into other loans, a CPLI strategy provides a significant Return on Equity (ROE), and even the opportunity to use these funds’ earnings to offer lower rates for borrowers giving these lenders a further competitive advantage.
Additionally, CPLI offers a key benefit for banks and credit unions planning or forecasting on a potential end-of-cycle event that could impact their loan portfolios. If for example a lender is projecting to adjust its overall underwriting at some future point based on current trends, and the market undergoes a much more drastic shift than anticipated, CPLI provides those institutions with better protection and peace of mind, allowing them the flexibility to “hedge their bets” against hard to predict occurrences.
Meeting Borrower Demands Equals Stronger Relationships
In addition to the improved risk mitigation and capital relief, one critical reason banks and credit unions should consider for implementing a CPLI strategy is that today’s CRE borrowers are already recognizing, and demanding, its benefits. According to a recently commissioned Harris Poll study, 79 percent of U.S. CRE developers would prefer to work with a lender that offered a non-recourse repayment option like CPLI for their loans over one that did not. What’s more, over half of those surveyed said they would be more likely to invest additional funds into a project to help resolve an issue if the original loan had no personal guarantee repayment requirements associated with it. Rather than threating a borrower with personal ruin, a CPLI approach provides CRE lenders the opportunity to solve problems in a much more cooperative and productive, rather combative, manner.
This data not only suggests today’s CRE developers (i.e., borrowers) are open to exploring other, newer options for their projects’ loans, but that they will actively seek out those lenders that have them. With many of today’s non-banks and alternative lenders in the CRE lending space already offering versions of non-recourse repayment options, albeit at higher rates and costs, banks and credit unions need to adopt similar strategies like CPLI to compete or risk losing ground – and market share.
While being an attractive option for CRE borrowers, leveraging CPLI as a component of a CRE portfolio strategy offers banks and credit unions a powerful customer service tool for enhancing those borrower relationships. With personal guarantees setting a somewhat adversarial tone right from the start of the borrower/lender relationship, they can make it difficult to establish a deeper trust between both parties (and ultimately be responsible for ending that relationship should a default occur).A CPLI strategy allows both CRE lenders and borrowers to begin their relationships with the peace of mind they will be protected in the event of a worst-case scenario, letting them focus completely on the success of the project.
What’s more, by offering borrowers a non-recourse payment option like CPLI, banks and credit unions could see additional loan deals not just from new borrowers, but from current customers and members. By removing the standard, traditional liquidity and net worth covenants connected with personal guarantee requirements, these borrowers could now be open to pursue additional projects. This not only gives their chosen lender the opportunity to close more CRE loan deals, but also create more cross-selling touchpoints.
The CRE industry continues to grow and evolve, with high levels of liquidity creating a profitable market opportunity for CRE lenders. With the rise of competition from both traditional financial institutions and alternative lenders, today’s banks and credit unions need every edge to gain ground, attract borrowers and close more deals. Those that can meet the market demands – adopting new approaches for their loan processes, like a CPLI strategy, offering borrowers a non-recourse payment option rather than relying on outdated, ineffective personal guarantees will be in a much better position to succeed and grow with the industry.
David Eichenblatt is the Founder and President of LGIS Group. LGIS Group is the pioneer of Commercial Property Loan Insurance (CPLI) for the CRE lending industry. LGIS Group’s innovative solution offers a proven risk transfer and mitigation strategy that can replace or supplement the personal guarantee for borrowers of typical short term, recourse commercial real estate loans. Providing significant capital relief to bankers and stronger credit, this empowers them to increase volume and profitability across their CRE portfolios with a competitive advantage and deeper customer relationships. To learn more, visit www.lgisgroup.com.