Do these four things each month to track and reduce risk

For many non-bank lenders, risk management is an activity they do before they get to the closing table. Lenders regularly evaluate the loan to value (LTV) ratio of the project when determining the creditworthiness of the buyer. The expectation is that if the borrower cannot repay the loan, the lender can cover the loss by foreclosing and selling the collateral. Certainly, after closing, the lender will keep an eye on the borrower’s debt service coverage—perhaps checking each monthly cash flow statement—but from a practical standpoint, that doesn’t protect against unforeseen events that may impact the lender’s level of risk.

The approach fails to consider events that impact that initial LTV assessment going forward. Those include rapid market drops like we saw 10 years ago and the opportunity costs of funding deals that default. The latter ties up capital that otherwise would have generated a higher ROI. So, it’s important to think of risk management as a continuing activity worth the investment of a few hours each month over the life of each loan.

One effective strategy for mitigating risk is to create a monthly borrower scorecard for tracking empirical data that are measured and evaluated over the life of the loan. Decide on a number scale—banks often use a 1 to 5 rating system for risk—and start monitoring regularly. The four steps that follow track risk at both the micro level (for a borrower and his or her local market) and the macro level (looking at markets and the economy).

1. Monitor Your Borrowers’ Projects
Mistakes are part of the business. For borrowers in new construction, adaptive reuse of commercial real estate, house flips and so on, every mistake, delay or cost overrun nips at the return they can expect to earn at completion.

Private lenders often know their borrowers well and feel comfortable with the level of scrutiny in the initial underwriting process. But, when a borrower runs into difficulty and a project no longer stands to yield a profit, a borrower’s mindset can shift without a lender noticing. The risk of a default materially increases, no matter how reliable the borrower has been in the past.

To monitor the potential for default and help your borrower stay on track, ask for a project schedule and budget updates. Then evaluate the mistakes, cost overruns, delays and so on, by assigning a score each month. You can develop your own algorithm to take into account the different components of the project. Try to keep it simple, and use a one to five or one to 10 scale. Months where the project is on schedule and on budget will rank on the higher end, and months where there are delays or problems
will have lower scores that reflect the challenges.

If a borrower has one or two months of low scores, that is an opportunity for the lender to engage with the borrower and provide some support for staying on track. Lenders may benefit from keeping a Rolodex of expediters, trusted contractors and other professionals who can help borrowers who are in trouble.

2. Develop Borrower Profiles
As a lender, you can’t read your borrower’s mind, but you can estimate how you think the borrower will behave if the project, market conditions or both should take a turn for the worse. Is he or she likely to dip into other sources of cash flow to continue servicing the debt? On the other hand, is it in his or her economic self-interest to default and drop everything in your lap?

If you’ve been dutifully tracking point #1, you’ll have some insight into the borrower’s mindset. This, of course, varies by borrower. The dispassionate numbers guy is likely to default faster than the egocentric backslapper who has pride, press clippings and bragging rights tied up in the project.

As part of your monthly review process, develop a profile for each borrower. Note what he or she does under stress, and identify potential pitfalls. As you identify situations that lead to default, you’ll be able to extrapolate to other borrowers with similar personalities or propensities. If you make repeat loans to the same borrowers, you’ll have a record of previous concerns and behavior to help you make decisions and monitor the loans you make.

3. Forecast Buyer’s Cash Flow in Different Scenarios
Most lenders get their borrowers’ monthly statement of cash flows. While this is handy information, it is backward looking. Healthy cash flow in June does not mean the borrower can service the debt in December. Regularly run some models to see how much liquidity the borrower will have in various scenarios. What if the project is delayed six months? What if the borrower’s project repeatedly fails inspection? What if the general contractor goes on a medical leave of absence? The purpose of this exercise is to identify pain points well before they happen. Then, as a lender, you’ll be well prepared if things do go bad, and you can determine whether it’s best to modify the note or go down the foreclosure path.

4. Update the LTV Appraisals
Too many loans rely on appraisals that were conducted during the origination process. These get stale over time. Changes in the market comps are a natural triggering mechanism for default, but the borrower has a much keener awareness than the lender as to when conditions are worsening.

Update the LTV by running “what if” scenarios, looking out 3-6 months or longer.
Be sure to closely examine local changes. Take, for example, the highly localized luxury housing market. In the Riverside/San Bernardino market, luxury real estate prices grew 11 percent in June, the most recent market data from Realtor.com. But contrast that with the Chicago market, where luxury prices are down 0.8 percent for the same period. And consider that the volume of luxury sales has slowed in 2018. Buyers are waiting on the sidelines to see how the tax changes affect them, and sellers are keeping prices too high because they’re aware that inventory is limited. A Chicago borrower creating luxury homes has less incentive to avoid default, while the collateral risk to the lender if the property is foreclosed is going up.

Yes, appraisals can be expensive and time consuming. But defaults are worse. If you don’t want to spend the money on a fresh appraisal, then get a comprehensive update on market comps and do the math yourself. This will allow you to understand whether your exposure is growing and can indicate when it might be a good idea to keep a close eye on a borrower’s project.

Well Worth the Time

A monthly scorecard approach is a great way to track and mitigate risks that inherently lurk in our industry. It takes time and a little elbow grease, and tracking golf scores is more fun. But over the long run, monitoring the risk for current projects will more than pay back in terms of money, time and fewer headaches. ∞