Risk And Reward
Ben Pauley explains the risks that banks are assessing when they look to lend money to a developer or investor.
1 June 2019
Working with development and commercial property funding, price is often an obstacle I come up against. Many people have limited understanding when it comes to riskbased pricing with banks, and when they uncover what that is, it can be a shock.
In simple terms, risk-based pricing is where the return for funding varies relative to the risk profile of that transaction. I say return as it encompasses both fees and interest rates. Banks (and almost all lenders) are required to allocate capital (money) to transactions and the quantity of capital allocated is determined by the risk profile of the transaction. The riskier the deal, the more capital required and therefore the higher return (rates and fees) demanded. What’s often forgotten is that banks are publicly traded entities with an obligation to return the maximum profit.
All lenders have internal-based return targets. In main banks these will sit somewhere around 25%-35% and some external lenders may even be higher. This is a targeted return on capital allocated to a transaction (that is hard currency held in reserve). Remembering that capital adequacy ratios are as low as 8% (for effectively risk-free transactions) meaning that for every $100 lent out there is $8 held in reserve. So, a 6% return on a $100 loan is actually a 75% return relative to capital allocated ($6 on $8). This varies again though with risk as the capital allocation increases.
All commercial business, commercial property and property development transactions carry a risk-based pricing approach that varies from transaction to transaction. There is a huge number of things that affect risk and banks take into account all of these things.
When a bank is assessing risk they first and foremost are reviewing a probability of default; what is the likelihood that the borrower will default on this transaction? This can encompass many things, but is usually broken into two areas – sponsor risk and transaction risk.
Sponsor risk: Who is the party behind the transaction? Do they have the capacity to inject capital into the transaction/project/business to avoid an event of default? What experience do they have? What is their integrity? Do they have a history with the lender? The bank is looking at the borrower and asking themselves what the likelihood of their success is and if in the event of failure, they have the willingness and means to avoid default. For this reason there can be real value in the relationships you build with your lenders/banks.
Transaction risk: This is a bit more long-winded as the transactions can vary so much, but there are some core principles in business which apply in general terms.
What is the profitability? What is the equity in the transaction? How liquid is the deal? Who are the key stakeholders (management, builders, QS, customers, suppliers, tenants, etc). What is the current economic climate like? For businesses their growth profile may be assessed (growth takes capital). For property deals they may be looking at the lease terms, tenancy profiles or even the profile of the pre-sales in a development.
The lender is effectively taking an objective position on the success of the transaction.
The second key driver in price is the risk of loss (albeit in the non-bank market this can also be a driver to the actual transaction also). The less likely a lender is going to lose money on a transaction, the better the transaction is likely to be priced. This is simply a measure of the security available. Most people will be aware of the amounts banks are willing to lend against certain assets (80% against an owner-occupied home, 70% against an investment, 65% against commercial property). The lower the gearing however, the less likelihood of a loss (a bank may take a 20% haircut on the fire sale of a property/movement in the market. It is much less likely to take a 50% haircut).
Regarding all criteria, remember that this is all relative to the current market and trends. The current market is buoyant and as such, banks have lent a lot in recent times resulting in them reducing their risk appetite (less risky transactions) and also placing more of a focus on profitability (higher rates and fees).
We are no longer in a race to the bottom with loose lending and price wars. Banks now have capital restrictions and are seeking the best possible reward for risk. Next time you are considering a transaction, think what you might do to lessen the risk profile. If you want to chat it through, contact a Squirrel advisor.