Income property loans and acquisition, development and construction (ADC) loans are among the most appealing, but also the most risky, types of commercial loans for a community bank.
Path to Growth
These loans include financing for small office complexes, owner-occupied real estate, apartment buildings, retail strip centers and stand-alone retail storefronts, which can utilize the expertise of community banks in the local market. Therefore, income property and ADC lending could be a path to growth in a competitive market for community banks.
However, success in these areas requires a keen understanding of how these loans differ from other types of commercial loans and from each other. For example, the primary source of repayment for an income property loan is the cash flow generated by the property, while the primary source of repayment for an owner-occupied real estate loan is the cash flow of the underlying business.
Success also requires an understanding of the factors that will influence the property’s revenue stream such as; local job growth, vacancy rates and operating expenses. These factors should be underwritten together, because when one changes, they all tend to change.
Income Property Loans
Currently, regulators are focusing on stress testing income property loans. Stress testing should be done both on individual credits and on the overall income property portfolio by sub-market.
On individual properties it is important to consider the lease rollover risk, because an income property’s revenue stream is primarily driven by its leases. This is especially significant when refinancing an income property. You should require borrowers to supply detailed rent rolls along with financial statements on an annual basis and look at the potential impact of maturing leases to determine whether the current income stream is sustainable going forward.
Two key areas to assess are what percentage of a property’s leases are maturing in the next 12, 24 and 36 months and how do rental rates compare to current market rates. If you see that a borrower might have an upcoming exposure to rollover risk, you can initiate a discussion about what can be done to mitigate the risk.
Lastly, physical vs. economic occupancy is a factor to look at when examining rent rolls. A property might be 95 percent physically occupied, but how many tenants were obtained with special lease deals? How many are delinquent on their rent? How many units are between tenants and generating no current income?
Acquisition, Development and Construction
The regulators’ focus for ADC loans, meanwhile, has shifted to include stress testing for absorption and the developer’s ability to carry a property for months at a time if it doesn’t sell. If the developer can’t carry the property, the regulators want to make sure the bank can, which requires stress testing at the portfolio level by the community bank.
Adherence to responsible lending practices can mitigate the risk of ADC loans, such as:
- Not compromising debt service coverage or loan-to-value ratios
- Requiring adequate equity injections by property owners
- Maintaining proper loan structure
- Physically inspecting properties
- Monitoring construction and marketing budgets
- Requiring liquid loan guarantors
If you have any questions about Income Property Loans, please contact us at 417-881-0145.