Advice

A Subtle Theft

Posted on November 7, 2022 Published by

If you know a thief is coming to steal your property, there is high probability that you would take precautions to stop the theft. But what if that “thief” is like carbon dioxide. A colorless and odorless gas and you don’t know it is there? What we may consider A Subtle Theft! Unfortunately, there are a couple of thieves running through the economy currently. The first, and the one getting the most attention, is inflation. It is eroding corporate and consumer buying power at a rate not seen in 40 years. A second thief is the increase in interest rates.

A Subtle Theft

In previous blogs we have discussed the need to carefully and critically look at the increase in interest rates and the impact on cash flow, with an emphasis on the need to “stress” existing cash flow of borrowers to evaluate the ability of that borrower to service its debt. This is of greatest importance on those borrowers who have debt service coverage below 1.2X in an environment that has seen extraordinarily low interest rates. But the increase in interest rates “steals” not only cash flow; it also steals value as in the appraised value of investment commercial real estate.

Interest Rate Increases

As interest rates increase, cap rates for investment properties increase, as well. As cap rates increase, appraised value will decline (all other things being equal). The cap rate (in its simplest form) is defined as the net operating income (NOI) of a property divided by the market value. While definitionally simple, it is part art and part science. Different asset classes will have differing rates reflecting the difference in risk. Multi-family projects have enjoyed a low cap rate. Current market environment exhibits low vacancies and ever-increasing rents. Office and retail sectors have been on the opposite end of the spectrum, with increasing vacancies and higher cap rates.

Cap rates can vary by market (geography) and timing. As appraisers look to develop an appropriate cap rate for a property, they will look for comparable properties in the same market and adjust each “comparable” for condition, repair, stability of NOI, etc. Often there are not sufficient comparable properties in the area, and so adjustments must be made to reflect differing market attributes. Also, how recent were the transactions? In all cases, appraisers are faced with looking at information from the past and therefore “lagging” real-time economic conditions both in terms of NOI and cap rates.

Past Correlations?

Some analysis has been done to determine any correlation between cap rates and the 10-year Treasury rate. A review of data from 1986 to 2021 shows that a 1% increase in the 10-year Treasury rate increases the cap rate by approximately 0.5%. Looking at the current rate environment, the 10-year Treasury rate increased from 1.62% in May 2021 to 3.45% (+ 1.82%) as of September 15, 2022. Assuming the correlation above, that would result in a 0.9% increase in the cap rate. While this does not seem too overwhelming, an example of the impact on a borrower’s loan to value is instructive. Assume a borrower purchased a property in May, 2021 for $1.2 million with NOI of $100,000. Cap rate equals 8.3%. Bank lends the borrower 80% or $960,000.

Fast forward to September 2022. Cap rate increases to 9.2% and market value would have declined to $1,087,000 assuming NOI remained constant. Which is a bad assumption in the current inflationary times. Loan to value has now increased to over 88% in 16 months. The Fed is considering interest rate increases between 2.25% and 3% by year-end 2022 which, along with monetary policy adjustments, will result in higher Treasury rates. Therefore, it is not hard see that a “thief” is stealing your collateral.

Cash Flow Impacts

As lending and credit professionals, it will be equally important to focus on the obvious cash flow impacts of rising interest rates and on the more subtle (or not so subtle) erosion of the lender’s collateral position. Lending institutions should use covenant defaults and/or upcoming credit renewals to update real estate appraisal values through either a rigorous appraisal review, new appraisal, or appraisal evaluation process. You may also consider a “targeted” loan review of borrowers in sensitive industries such as lodging, office and/or retail. Third party appraisal evaluation firms could provide valuable input as well in terms of reviewing dated appraisals.

In this case, we know there is a “thief” lurking in the economy. We should heed the warning and take precautions.

 

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.

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“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors.”
— Bill Beardsley, President, Michigan Business Connection
“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors."
— Bill Beardsley, President, Michigan Business Connection