How Commercial Property Loan Insurance Could Make You Recession-Proof
By David Eichenblatt
August 12, 2019
David Eichenblatt is President and Founder of LGIS Group, Atlanta. He has more than three decades of experience as a commercial real estate investor and developer. www.lgisgroup.com.
In the time just prior to the Great Recession, the commercial real estate lending market was very competitive, not only with rates but also loan structures. Collateral requirements were creative, with developers able to leverage bankers into what were known as "Entity Guarantor" structures. This allowed one big pot of liquid collateral in a newly created entity to serve multiple CRE projects and lenders.
While everyone recognized the inherent risk that one failed project or lender could potentially drain the pot for everyone--leaving all the remaining participants, or loans, with nothing to fall back on to make them whole--they carried on with business as usual. Ultimately, this would prove disastrous when the downturn unfolded.
Successfully gaining market share is directly tied to a lender's ability to manage and mitigate its risk. Similar to private mortgage insurance in the residential mortgage finance market, commercial lenders need a means to pass on some of this risk, rather than holding it all in their own portfolios.
Recent, modern innovations in investment-grade insurance products can provide banks with both the structure and liquidity required, and most importantly, risk coverage for all projects and lenders on an individual basis. Notably, this would expand cumulative coverage and eliminate all lender exposure, bringing an end to the instances of zero available funds that characterized the pre-recession era.
As we approach the end of yet another real estate cycle, CRE lending continues to grow, with commercial investments in the U.S. topping $122 billion in 2018. Lenders are seeing increased demand for capital as developers respond to positive financial trends. This rising competition among lenders, unfortunately, is driving reappearances of the same, disastrous loans structure, like the prior mentioned, ill-structured Entity Guarantors, due in large part to the lack of available alternatives for risk mitigation or transferences in the CRE industry.
Today, the industry is seeing both private and institutional investors trending back in time towards a knowingly faulty entity guarantor collateral loan structure for CRE loans. To illustrate:
Option One (Existing Approach): An institutional investor fund holds five loans totaling $500 million. In this scenario, all banks use one liquid collateral ‘pot of cash' equivalent of $20 million for all five loans. Each bank acknowledge that one lender can drain the $20 million of liquid collateral, leaving all four other lenders with no cash equivalent liquidity.
Depending on the borrower, this pot of liquid collateral is often 7.5 percent to 12 percent (with some aggressively rated as low as 5 percent) of cumulative loans and is most likely held in T-Bills--which have a current rate of 1.74 percent as of July 2019.
Rather than traveling down this same, potentially risky road, it is important for lenders to consider alternatives that would prevent any one lender from being left without repayment from a drained collateral agreement. Increasingly, lenders are adopting a commercial property loan insurance strategy to provide structure, liquidity and enhanced risk mitigation. This lower risk profile also allows banks to offer lower, more competitive rates. By comparison, an alternative to the prior approach using a CPLI strategy to enhance the risk mitigation/transfer would be:
Option Two (New Approach): A liquid collateral pot of cash totaling $5 million, with additional individual loan insurance for each of the five loans. The insurance range for each loan would be between $10-15 million. If we use the upper end of this range, the cumulative amount of lender protection would total $80 million.
This can be graphically illustrated as:
From an informal survey of lenders and chief risk officers at large money-centered, regional and community banks, 100% all chose Option Two over Option One--along with confirming a lowering of rates by 15-25 basis points, due to lower risk profile.
Another example illustrating the large economic benefits for borrowers, and large gains in more security and lower risk for lenders can be illustrated here:
Through a similar strategy, borrowers/developers can effectively reduce their liquidity collateral requirement from $50 million to $10 million. The $40 million difference can now be redeployed into the core business--earning upwards of 20 percent versus 1.74 percent in T-Bills. Lenders will also realize an improved rate of .25 percent. Potential borrowers are now looking at a much more open balance sheet, and given the example above, a potential net positive increase of more than $17 million, after the cost of the insurance, plus interest rate savings of nearly $3.75 million. This amounts to a total benefit of more than $20.75 million, and a very scalable business model for both borrower and lender, while doubling the security for the lender ($100 vs. $50 million loan). The concept and results are just as impactful with smaller sums for private investors.
With the projected slowing of the overall economy and the near-term "end-of-cycle risk" in CRE lending, adopting a more modern CPLI strategy in CRE loan underwriting answers many of challenges facing lenders in the marketplace, including increased competition from both traditional financial institutions and newer, non-bank and fintech lenders.
The traditional personal guarantee requirement for borrowers, along with the reintroduced Entity Guarantors, are known yet outdated standards, but they are no longer the only options for lenders who want to grow their CRE portfolios. The basic loan structure most CRE lenders are familiar with can be improved through the adoption of a CPLI strategy, providing net advantages for both lenders and borrowers. Borrowers now have increased protection in an improved business model with tangible economic benefits, and lenders benefit from a boost to their competitive advantage while significantly lowering risk. Ultimately, this allows CRE lenders to better serve their customers, expand lending capacity and increase operating efficiency while avoiding the pitfalls of the previous era's bad loan structure policies.
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