Bankers Need To Understand Borrower ROE

Bank Lender Training

The future in banking looks like fewer, but more experienced bankers. Consolidation of banks will continue, but more digital-based alternative lenders will appear. The banker that can deliver solid financial advice to their client will always be in demand and will be able to garner a premium price for his or her services. This is germane, as our recent survey on the Future Forces of Banking (HERE) shows that more than 81% of bankers see their businesses being impacted by online alternative lenders over the next 5 years. To combat this trend, to increase job security and to ensure better service to our future borrowers, one tool that every banker should have in their arsenal is the ability to understand how a real estate investment works from the borrower’s perspective. While professional real estate investors know this cold, what we find is that our bank can be of huge service to helping our small and mid-size businesses understand how and when to purchase their own facilities. While the lease vs. buy decision is well understood, what is less understood is what the current opportunities are and how much rising rates impact our borrowers.


The Base Case


Current capitalization rates are at about a 6.3% for quality commercial buildings (retail, office, industrial, etc.). For a quality borrower, we will assume of +200 basis points over a floating or fixed rate index, we hold property appreciation flat (a big assumption, which we will relax below) and we calculate  a return to the investor of 10.9% for a loan at 65% loan-to-value (LTV) and a 13.6% return for a loan at a 75% LTV. This return now serves as a base case to make a decision. If the borrower can deploy their capital in a better investment (like maybe more equipment) then they should lease their building and put their capital to work by buying equipment all other factors being equal. If no other alternatives exist, then purchasing real estate may not only be a good investment but may create some additional intrinsic value in the business by allowing for more stability.


Practical Advice For Professionals To Help Drive Loan Volume


The above outlined returns and reasoning have been a major driver to some of our marketing campaigns. Medical groups (really all professions), for instance, don’t need major infrastructure so purchasing their building not only has the above ROE advantages but helps with tax planning and efficiencies. While each partner might be able to invest in real estate on his or her own, financing their own business creates some efficiencies of scale, plus comes at zero credit risk since they would be responsible for their own mortgage payment. As such, setting geography aside, purchasing their own building might be the best investment they could make.


What Happens In a Rate Rise?


Bankers need to not only understand how potentially rising rates could impact their own bank but how rising rates could impact their own investment decision. To the extent your borrower’s lock in fixed rates, then nothing happens to their return (all other factors held constant). To the extent they have floating or adjustable loans, then rising rates would currently impact them as detailed below with the most likely scenario highlighted in yellow:

CRE Borrower ROE


As you can see, the more leverage a borrower has the more they are impacted by rising rates. This is why understanding their business model and rate view is the key to offsetting this decrease in ROE. If the business benefits from higher rates, then the value of their business would grow acting as a natural offset or hedge to their real estate investment.


What Happens With Changing Property Values


In the above discussion, we held the value of the property constant. Bankers need to discuss what happens if the value of the property changes. The chart below shows what would happen to the borrower’s ROE if property prices appreciated or depreciated 5%. This is currently a topic of hot debate as to whether rents can keep up with the current pace of building and lease up. To the extent you/your borrower believe that the economy is healthy and can sustain an increase in rates than the former scenario is most likely. However, if you are in the camp that the economy will slow with the rising rates, then a 5% drop in property values may be worth your investment consideration. 

The Borrower Perspective


Putting It All Together


Even with a 1% increase in rates and a 5% decrease in property values, a 9.4% return is still attractive given other alternatives such as the equity markets or annuities, especially in light of the other tangible and intangible benefits of owning your own office or facility might impart. Further, for most professionals the ability to control their primary business premise is a big strategic advantage for their business. As you can see, a banker that can talk investment return over a variety of scenario is better positioned to add value to the relationship more than any website currently could. The rise of non-bank competition has created a need for bankers to take more of an advisory role, and we feel that the return analysis presented above is just one small example of a way bankers can help their borrowers make informed financial decisions.