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.
* * *
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