Big CRE Lender Makes Case for High Concentrations

Don't worry about our commercial real estate exposure.

That was the key theme of Bank of the Ozarks' second-quarter earnings call. Management spent a lengthy portion of opening remarks outlining conservative underwriting principles while assuring analysts that they are taking steps to diversify the $12.3 billion-asset company's loan mix.

"We have been working over the last several years to improve our competitive advantage in other areas," George Gleason, Bank of the Ozarks' chairman and chief executive, said during Monday's conference call.

The company is expanding in a number of specialty products, including government-guaranteed loans, poultry lending and credit for indirect marine and recreational vehicles. Most of those capabilities stem from past and pending acquisitions, Gleason said. Two acquisitions — C1 Financial and Community & Southern Holdings — are set to close by the end of this month.

Bank of the Ozarks also plans to expand its own leasing and investment securities portfolio platform.

"While we expect our CRE lending volumes to continue to increase significantly, we expect these other areas to grow even faster," Gleason said.

Ozarks, as a result, plans to reduce its historical dependency on CRE, which it said should contribute to about 57% of quarterly loan growth by 2018. Commercial real estate, including construction and development loans, accounted for nearly three-fourths of the company's loan growth in the first quarter. (It did not break out second-quarter loan growth by category.)

The guidance follows rumblings that regulators are paying more attention to banks with high concentrations of CRE loans. Some bankers have expressed concerns that certain banks could be required to hold onto more capital.

The discussion also comes two months after Carson Block, founder of Muddy Waters Research, claimed that Bank of the Ozarks had been downplaying the riskiness of its construction loans. He also criticized Bank of the Ozarks' acquisition strategy, telling attendees at a forum that the company's growth depends on deals.

Gleason downplayed those concerns.

"When bank regulators first introduced their CRE concentration guidelines in 2006, our CRE ratios were well over the guidelines, just as our CRE ratios are today," Gleason said.

"We were comfortable then with our level of CRE lending and … we are even more comfortable with the quality of our portfolio, our exceptional rate of portfolio growth, and our CRE levels today," Gleason added. "The regulatory guidelines mandate that if you have a CRE concentration, extra safeguards should be in place. We totally agree with that."

The "biggest risk" is whether regulators come back and ask the company to add more capital, said Catherine Mealor, an analyst at Keefe, Bruyette & Woods.

"Certainly that's a risk but I think, given the way they've underwritten these projects, the leverage on the projects and their history, I think there's really not a lot of ... inherent risk in the portfolio," Mealor said. "I think they're going to be able to continue to keep this level of commercial real estate to capital that they have in the past."

The company, meanwhile, recently raised $225 million by issuing floating-rate subordinated debt.

While Ozarks should feel comfortable about its CRE book, diversifying into areas such as poultry and consumer lending, could ding the company's profitability, Mealor said. "It's tough because the losses on the commercial real estate book have certainly been the best of any asset class they have," she said.

"As they diversify away from that and they get into all these other business lines, the yields might be higher … [but] they're going to have higher losses on those products," Mealor said. "It's just kind of the nature of those asset classes versus this very high-quality construction portfolio."

Loan growth played a major role in the company's quarterly results. Net income rose 22% from a year earlier, to $54.5 million, while earnings per share of 60 cents topped the average estimate of analysts polled by Bloomberg by 2 cents. Total loans increased 48% from a year earlier, to $9.7 billion.

Management also discussed how they were funding the loan growth, admitting that they had been offering deposit specials in certain markets, with pricing anywhere from 1% to 1.35% for 10- to 15-month CDs.

"We're monitoring those markets and … competitors on a weekly basis," Tyler Vance, the company's chief operating officer and chief banking officer, said during the conference call. "We've seen a little moderation in pricing in some markets, so we'll probably look to lower a little bit of our rate in the 15-month term."

Gleason also said during the conference call that loan growth was accelerating, and he raised his 2016 forecast by 17%, to $3.5 billion. The upbeat assessment reflects "excellent year-to-date growth, the growth in our consumer base, our pipeline of transactions currently in underwriting and closing and our largest ever unfunded balance of closed loans," he said.