Credit Risk and the Real Estate Market

Credit risk is the oldest and the most known banking risk. Credit risk is the risk to earnings or capital arising from a borrower’s failure to meet the terms of any contract with the bank or otherwise fails to perform as agreed. Shortly, credit risk is a situation, when a borrower is not able or does not want to pay back a loan to a lender. There can be two reasons for default: firstly, the borrower cannot manage his/her specific business risks, and secondly, the borrower has been dishonest.

Given the nature of most commercial real estate markets, the financing of commercial real estate is subject to an exceptionally high degree of credit risk. The limited supply of land at a given commercially attractive area, the exceptionally long economic life of the real estate assets, long delivery time required for the development and construction of major projects, and high interest rate sensitivity have given commercial real estate markets a long history of extreme cyclical fluctuations and volatility. In the context of commercial real estate lending, the bank’s credit risk can be affected by one or more of the following risks that endanger the borrower:

A real estate project can expose the borrower to risk from competitive market factors, such as when a property does not get lease-up according to plans. These competitive market factors may have their origins in overly optimistic initial projections of demand and over estimated cash flows, or they may be increased by a decreasing of demand during or shortly after the completion of a project. Competitive market factors can be compounded by a high volume of distressed property sales that can decrease the value of other properties in that local market. Investors, who buy distressed property, can charge lower rents, persuading tenants away from competing properties and bidding rents down.

Rollover of leases is another risk to the borrower that is present in most commercial real estate projects. Real estate markets with long-term leases are particularly vulnerable to declining values. In extremely depressed real estate markets, leases have typically been cancelled in the mid-contract, as tenants went bankrupt or out of business or simply threatened to move out unless their leases were overviewed. Additionally, competing owners with large amounts of empty space have been known to buy-out existing leases in order to attract tenants to their properties. The value of even fully leased buildings can decline when leases must be reduced or extended at lower, current market rent levels. As leases cause project cash flows to decline, the borrower may become unable to meet scheduled mortgage payments.

The changes in the regulatory environment and legislation are risks for borrowers and developers. Commercial real estate developers/ borrowers must consider and plan for the risks associated with changes in their regulatory environment and legislation. Changes in zoning regulations, accounting and tax laws, and environmental regulations are examples of local and governmental regulations that have had a significant impact on property values and the economic feasibility of existing and proposed real estate projects.

A developer faces construction risk that a project will not be completed on time or at all, or that building costs will exceed the planned budget and result in a project that is not economically feasible.

Of course every respectable bank conducts the credit history research of borrower and analyses particular business project, before it lends capital out. This is one way to reduce credit risk, but this is not excluding it. Wherever the credit is expanded it is attended with the risk of non-payment varying from zero to a large percentage. History has shown that even “the best business” idea has failed. A lender has to consider different factors in regards to borrower, which affect a loan and a bank’s loan portfolio. A bank has to deal with all these factors, while analysing loan projects and observing loan repayments.

  • The quality of information about a borrower. First of all credit risk depends on information, which is available for the evaluation of certain projects and borrowers. The more incomplete it is the bigger the credit risk.
  • The borrower’s credibility. Credibility is directly related to information. An honest borrower always presents true information. To give a loan to such borrower is less risky, because the bank hears about the borrower’s problems earlier. The risk is bigger if the borrower is dishonest and tries to cover financial troubles or present wrong information.
  • The borrower’s cash flow level and its stability. A bank gives a loan to a borrower under the assumption that the loan will be repaid. This is done by using future earned cash flows. Borrower’s cash flows depend on how capable a borrower is to manage his/her business risks. Thus, the loan repayment is more certain the more positive and stable these cash flows are in the future.
  • The borrower’s net asset value. The net asset value (NAV) is the difference between a borrower’s assets and liabilities. Default risk is smaller, if1 borrower (enterprise, company) has a bigger NAV, and it is higher with low NAV.
  • A collateral. By giving a loan a bank assumes that it will be repaid by using income or cash flows. But cash flows or income are not always stable and positive. Thus, a bank may demand additional collateral, which can be sold after a borrower’s default to repay the loan. A collateral can be an asset (a house, land, stocks, etc) or a warranty of the third parts.
  • An economic environment. The magnitude of credit risk does not depend just on a borrower. It is strongly affected by a region’s macroeconomic factors (inflation, the levels of interest and exchange rates, employment, business cycle), a political situation, legislation etc.