Commercial Real Estate Finance

Imagine if you were looking to make an acquisition and you approached a bank for a $750,000 loan that is 80% LTV. The property that you are looking to acquire is covering just north of 1.10 DSCR and is throwing off an NOI margin that is 55% of lease revenues. No way that deal is getting done today, right? Well, deals like this were a piece of cake back in 2005-2006. Of course, the flip side of the coin is that deals that were done in 2005-2006 are performing so miserably that banks are having massive debt impairment issues. We hear about it in the press everyday—“such and such” bank needs to find a way to recapitalize or they will be forced to take a capital infusion from the federal government.

So we see it in the press, but what does the equity shortfall on a poorly performing property actually look like on the bank’s balance sheet? How badly is the bank undercapitalized? To try and answer these questions, we’ve drawn up the following example of a typical deal done back in 2006 to illustrate the impact an underperforming property has on a bank’s capitalization.

You can see that we have made some assumptions that were pretty typical of a deal done in early 2006.  The loan used to purchase the property is $733K, which is 80% of the property’s value at origination.  As cap rates start to ratchet up over the next few years and lease up rates fall, the property valuation begins to suffer. The total property value falls below the original loan amount, creating an equity shortfall in the property. The question here becomes: Is the bank capitalized well enough to meet this equity shortfall? Well, let’s see:

If the bank itself is leveraged 85% that means that only 15% of the capital made available to the borrower was from the bank’s own pool of equity. In this example, it is clear that the amount of equity the bank has behind this property is not sufficient to cover the equity shortfall. On this small loan of just $733,000, the bank needs an additional $247,000 of equity to match the equity shortfall in the property before it starts performing again. Multiply this effect over a whole portfolio of loans that are much larger and you can easily see why the media reports on the huge sums of additional capital needed by bleeding banks.

Prior to this exercise of working through an example where an underperforming asset results in a capitalization shortfall on the bank’s balance sheet, I never really stopped to think about the recapitalization requirement the federal government has placed on suffering banks. After working through this example however, I’m beginning to ask myself whether I’d rather just see the bank go out of business as opposed to putting an equity band-aid on its bleeding balance sheet.