This post was co-written with JJ Medina, Managing Director ~ Enterprise Software Solutions for Financial Services at Pitney Bowes
Commercial Real Estate (CRE) is at a risky inflection point. The rate of charge-offs (when the value of loans are removed from books and charged against a loss reserve) are essentially at zero while delinquency rates are also at a historic low (see charts below). Low charge off and low delinquency rates along with increased competition for new loan business are tempting banks to relax CRE lending standards and give out risky loans. This is a major cause for headache among regulators as the CRE market continues to overheat and property values surpass pre-bubble levels.
CRE underwriting and portfolio monitoring is not a black and white exercise, nor is there a simple formula or model that fits every lending or risk management scenario. This post explains how a location-based CRE risk management solution will enable analysts and portfolio managers to adapt to market uncertainty and to capitalize on opportunities.
What’s Making News
It has been 10 years since the last major recession and the headlines are full of uncertainty and caution of an overheating CRE market and unprecedented levels of debt.
|Jun 21, 2016||Fed Says Vulnerable CRE Sector Could Take Hits|
|Feb 15, 2017||Fed is Starting Getting Worried about $2 Trillion Real Estate Market|
|Mar 23, 2017||A Fed Official Warns that Another Real Estate Bubble Could Collapse Financial Stability|
|May 9, 2017||S&P Warns of Risks as Banks Lending for Commercial Real Estate Exceeds 2008 Peak|
|Dec 5, 2017||Moody’s Warns of U.S. Real Estate Office At “Cyclical Tipping Point” That Will Devastate CMBS Market|
|Mar 6, 2018||The Much Prophesied Commercial Property Bust Still Hasn’t Happened|
The headlines above demonstrate uncertainty in the real estate market, ranging from warnings of an impending bust to pointing out that the bust didn’t happen. Ultimately, the future is uncertain and your success is dependent on how well you adapt and respond to events as they happen. It’s important to have timely and actionable data and how you put that data to use is critical to the success of your risk mitigation and revenue generation strategies.
For medium and large firms alike, adapting to uncertainty is limited by the traditional types of analysis being employed today. It is typically done on static or stale property pro-formas, rent rolls, forecasts, and outdated appraisals. Additionally, the mix of excel spreadsheets and disparate scoring systems makes for inconsistent and unreliable analysis of commercial real estate loans.
The Need for Comprehensive View of the Property
The first step in measuring the performance and value of a property is to assess its income potential and the factors that drive it. Property net operating income (NOI) is impacted by several factors including management quality and tenant and lease structure. They are directly impacted by other factors as well, including economic vitality, changes in demographics, crime, and location desirability. Geo-demographic characteristics at a property location and at a regional level are becoming more important for CRE analysis. Because of this, practitioners are looking for these types of data sources to supplement quantitative analysis and to gain a better understanding of what’s going on around their properties.
Below, we give two examples of how to enable analysts and portfolio managers to make better informed commercial real estate lending decisions and to enhance credit risk assessment.
The Importance of Enriching CRE Quantitative Analysis with Alternative Data Sources
One way to move forward is to correlate the bank’s real estate loan portfolio and quantitative analysis with alternative data sources like location intelligence, including the following:
- Accurate and more granular parcel boundaries and attributes that provide greater insight into the property and surrounding areas.
- Mapping and satellite imagery to visually confirm property and tenant locations.
- Crime index data to evaluate the safety and quality of trade areas and neighborhoods.
- Consumer segmentation to understand local lifestyles, geo-behaviors, and demographic changes.
- Consumer vitality to describe the socio-economic desirability of the region.
The data above provides timely and actionable information that will enable portfolio managers and analysts to quickly identify non-performing properties that may increase CRE portfolio risk.
Leverage Advanced Analytics to Manage Risk and Make Better Decisions
The adoption of data science and advanced analytic methods is growing and being leveraged throughout the commercial real estate industry and can be used to enhance the credit risk assessment and the probability of loan default across all properties and portfolios. The key to this, however, is to connect the analytical results directly to the real property, otherwise there can be a disconnect between strategic aims and real outcomes.
An example of how this might work can be seen in the image below. In it, a heat map is used to display the results of risk models from operational data like loan origination, collateral, credit analysis, and credit risk systems. Each property associated with a block of risk can be further analyzed using location data in the following ways:
- Select a CRE portfolio segment and start your analysis on significant changes in credit risk.
- Monitor changes in location scores based on location desirability and other factors.
- Drill down into multiple or single view of properties and visualize changes in crime, demographics, and geo-behaviors around the property that may influence vacancy rates.
- Visualize and analyze market trends, comparable properties, and competition for current and future construction financing projects.
- Analyze neighborhood and commercial boundaries in the same platform, to more accurately assess the repurposing of commercial properties, from strip mall, to warehouse, to mini-distribution hub.
Responding to Uncertainties Requires New Capabilities
As described earlier, adapting to uncertainty is limited by the traditional types of analysis being employed today. Below we identify capabilities that will enable analysts and portfolio managers to make better informed commercial real estate lending decisions and to enhance credit risk assessment. These capabilities are described as the response to a series of trends and respective implications.
|Unprecedented debt held by banks and consumers, surpassing the 2007 financial crisis levels, are making banks, investors and regulators nervous.||Driven by the fast-approaching deadline to implement FASB Current Expected Credit Losses (CECL) accounting standards, financial institutions will require additional sources of third party data to sufficiently prove and track the dynamic relationship between the macroeconomic variables, and CRE space and assets markets.||Supplement current quantitative analysis with alternative data sets in order to fully understand and anticipate local geo-demographic trends that affect property cash flows.|
|The adoption of data science and advanced analytic methods is growing and being leveraged throughout the enterprise.||New business processes require collaboration across business functions on shared data sources. The accuracy and integrity of data is more critical because each group needs to work with the same version of the truth. Regulators require that the fidelity of data is ensured.||Visually analyze raw data directly within a data lake (lines of business, product lines, jurisdictions, etc.) so that business users can correlate data at a granular level and aggregate those results up to the enterprise level. This mitigates the errors that occur during the extract, transform, and load processes required by traditional BI platforms. Data fidelity is ensured because data is not moved.|
|Over $90 billion of CRE loans are coming due this year (Loans that were underwritten during the last recession), so regulators want to make sure lenders are properly assessing the performance and risk of these loans and properties.||An accurate evaluation of collateralized properties, including values and location desirability is critical to assess loan performance at any given time. Lenders and regulators know that location desirability has a direct impact on property cash flow and Net Operating Income (NOI).||Incorporate customer, property, credit data, and advanced analytics into one enterprise-wide view by leveraging native visual analytics on a location-based data lake to increase regulatory and operational efficiency.|
|The Federal Reserve’s plans to raise interest rates.||Negative pressure could be applied to customers and banks at loan renewal time but other risks can be mitigated. Rising interest rates can temper the risk of oversupply in the high-end property market by motivating borrowers to be more prudent with seeking financing on new construction.||Be hypervigilant about the markets in which you invest, down to a neighborhood-by-neighborhood, street-by-street level in order to mitigate risk and capitalize on opportunities.|