As we have all heard by now, Silicon Valley Bank and Signature Bank suddenly crashed by epic proportions in recent weeks— a crisis that represents one of the largest bank failures since the financial crisis in 2008 and has sent shockwaves through the banking industry.
The events here were largely due to the steep increase of interest rates from the Federal Reserve to fight inflation, which in turn resulted in investment losses. These losses, in turn, created a lack of cash reserves to support customers withdrawing funds at the same time (also known as a bank run). In an effort to stop these banks from completely bleeding out and to protect depositors, the FDIC cauterized the wound by seizing the bank’s assets after the institutions were shuttered. To prevent this event from inciting a financial crisis across the entire US banking system, the FDIC has promised to safeguard all assets, even if they are over the standard maximum $250,000 of covered deposits.
Were there red flags or warning signs?
The FDIC is facing scrutiny for not identifying the risk through regulatory oversight and thus preventing the downfall of these institutions earlier. The collapse of these two major banks has raised many questions around the current guidelines put in place, intensifying the pressure for stronger regulations.
While it is still too early to predict the full impact the collapse of these banks will have on the US financial system, the government’s response to stop an ensuing financial crisis is a leading indicator of a shift towards more rigorous regulation and oversight of the banking industry — particularly in risk management and lending. This is also a reminder that seemingly secure financial institutions are not indestructible and are at risk for potential instability and demise. With this in mind, it’s important to keep the health of your portfolio at the forefront of your attention and to stay on top of rigorous regulatory scrutiny.
Here are 5 things YOU can focus on when managing your CRE portfolio:
Portfolio and deal level stress testing
Stress testing allows you to identify the adequacy of an investment when tested against different economic scenarios. It’s important to perform stress tests to diagnose potential risks that can have an adverse effect on your portfolio. Stress testing is imperative as it can guide capital and strategic planning for investors and banks alike. Forecasted losses can also help financial institutions brace for impact by indicating that an adjustment to their loan loss allowances is needed. The market and economy is fluid, and as such, the results of a stress test should be used to help create and update the strategic plan and validate key risk indicators in order to pivot when needed to accommodate evolving conditions.
Property cash flow analysis
The value of a commercial real estate asset is directly correlated to and driven by the amount of cash flow the property produces. Property cash flow analysis is important because it can help identify the amount of annual income produced from the operations of the property AND the value of the property at time of sale. It is also important to determine if the projected cash flow is able to service the debt of a loan. The DSCR is a key indicator of whether the property is performing well or not and should be a cause for concern when below the minimum outlined contracted ratio. There are many different cash flow models that can be taken into account when determining the health of your property. Historical data can help identify the rate of growth or decline throughout time. In place P&L data can show how well the property is performing today with current information. A discounted cash flow model can help estimate future cash flows of an investment based on assumptions. In reference to the future regulatory climate, understanding the cash flow of your property will keep your finger on the pulse of your investment, giving you time to resuscitate before a potential flatline.
Borrower and guarantor financial spreading
It has never been more crucial to stay on top of covenant tracking and financial document collection. Like the SVB financial oversight, it can be detrimental to a deal and portfolio if you don’t track the financial stability of the borrowers and guarantors associated with debt at your financial institution. A dip in income or a lack of liquidity can determine a borrower’s capability to repay the loan. Creating liquidity and financial provisions in the loan agreement covenants is a way you can require a borrower to maintain a certain amount of cash and marketable securities and continuously assess their assets and liabilities over the lifetime of the loan. The liquidity and net worth ratios can strengthen your oversight of the borrower’s financial position and can identify earlier opportunities of intervention when necessary.
Current Market Data
Current market data is imperative when analyzing the risk of a current loan. Market data can help you identify factors that could negatively impact the performance of a loan and portfolio related to the asset type and submarket you are lending in. Pulling sales comp data can help you assess the value that other similar properties sold at, ultimately assisting in creating current valuations for your portfolio of properties. Rent comps identify the current going rate for comparable properties by unit type, which is invaluable when creating projected gross revenue and property cash flow. Submarket data can highlight the stability of an asset type through data points such as vacancy rates, cap rate, asking and effective rent, competitive inventory, household formations, and absorption. These data points will assist you in making educated decisions and assumptions regarding the performance of your deal.
Key Performance Indicators (KPIs)
KPIs are metrics used to measure how well your property is performing to maximize profits. They can help you take a proactive approach to managing your portfolio when used to identify potential risk. Some important KPIs I recommend keeping your eye on are revenue growth, vacancy or occupancy rates, tenant turnover, rent prices, LTV, DSCR, and debt yield. Depending on the goal of your institution, and the health of your current portfolio, the KPIs you choose to track may vary, so it is important to remember to measure and track KPIs that are meaningful to YOUR organization. Once your KPIs are determined, use these as a guide to identify any issues within your portfolio, identify opportunities to improve upon (at a deal or portfolio level), and ensure alignment with the strategic objectives of your organization.
Although data points, metrics, and information are all important, they are useless on their own. It’s what you do with this information that is important. It is up to you to provide context to the data and create a compelling case for what the data means to the health of your portfolio. Investing in technology that can clearly present and track this data in a digestible format will help you take an organized and data driven approach that is more impactful and valuable to monitoring the success of your portfolio and organization. Doing so can make all the difference in staying ahead of regulatory changes in the current market and avoiding unwanted outcomes.
ABOUT THE AUTHOR
Laura Taylor (Bohlmann)
Laura Taylor is Blooma’s CX aficionado with a demonstrated history in financial services working for companies like JP Morgan Chase & Co. and local favorite, San Diego County Credit Union. Today, she uses her extensive experience in CRE lending and underwriting to help Blooma customers everywhere level up their CRE lending.