A longtime metric used by banks to evaluate the strength of their commercial real estate portfolios isn't as useful as it once was
Loan-to-value ratios, or LTVs, have historically been a key tool for underwriting real estate loans, allowing lenders to gauge the risk of debt going sour by comparing the amount borrowed with the value of the asset being financed. The lower the LTV, the greater the lender's equity cushion.
Banks use the metric as part of the equation when they underwrite loans — and regulators require them to do so — to determine how much capital they must stash away in case of a credit downturn.
But a years-long, nationwide recalibration of commercial property values has rendered appraisals, and LTVs by extension, irrelevant, say investors and traders. Valuations – the "v" in LTV – have become more difficult to ascertain due to a sleepy deal environment, pandemic-related trends poking at revenue and a stretch of
John Toohig, head of whole loan trading at Raymond James, said that assets like office towers and apartment buildings are typically priced based on some combination of their recent sales tags and their potential revenue production. After transactions ground to a halt in the high-interest-rate environment, and work-from-home trends warped income projections, brokering deals is a different game, Toohig said.
"LTV is not even a number we use anymore," Toohig said. "LTV has no value at all. The only thing that matters today is cash flow, cash flow, cash flow."
To their credit, lenders aren't blind to the limits of the LTV's utility, especially in the current environment.
Valley National Bancorp President Tom Iadanza said the metric is one of a
Iadanza said LTVs are still useful as a general barometer, but banks need to periodically stress test their loan books and modify those values based on present economic factors, which have largely depressed income generation in the last few years.
"If you're not adjusting your cap rate to current market environment, then [LTVs] are not useful. They're misleading," Iadanza said. "If you're not underwriting to existing cash flow, then the valuation won't matter because your debt can't be serviced."
Iadanza said the turmoil in the CRE industry has made banks less trusting of LTVs in their lending decisions. He added that many lenders have "learned their lesson" by dealing with problem assets.
In the last two years, lenders have ratcheted up their provisions for credit losses in light of some property values nosediving. Megabanks like JPMorgan Chase, Bank of America and Wells Fargo —, along with regionals like PNC Financial Services Group, Citizens Financial Group,
Banks that are in the CRE business often tout their prudent lending strategies, citing a laundry list of variables beyond LTVs that factor into how they allocate money.
"LTV's are an important component of our underwriting but ultimately we size and evaluate our loans on overall cash flow," said Sam Hanna, who leads CRE lending at Webster Financial in Stamford, Connecticut, in an email. "In today's environment, cash flow and corresponding [debt coverage ratios] are much more reliable indicators of an asset's relative performance than LTV."
In investor presentations, Valley lists LTV — which averaged 57% across its CRE portfolio, as of the second quarter — to highlight the bank's underwriting, Iadanza said. Even though the LTV values for specific loans are based on appraisals that may not be up-to-date, the bank is confident in its risk profile, he said.
In June, Moody's Ratings
Darrell Wheeler, head of commercial mortgage-backed securities research at Moody's, said the firm's findings nonetheless show that most banks have enough equity to cover their CRE loans. He added that lenders with more exposure to the sector also have more expertise, and understand that property values move, even in less turbulent times.
Still, LTVs aren't going anywhere, say participants across the industry. Rather, as rates stabilize and real estate deals come back to life, valuations will likely regain the confidence they once inspired in investors. When that might happen, though, is up in the air.
Megan Fox, a senior analyst in the financial institutions group of Moody's, said that in the interim, banks are offering more data to investors. That information includes maturity profiles, debt service coverage ratios and disclosures about their exposure to different office subsectors.
"LTVs are a useful measure for bank investors because they're a clear, easy-to-understand concept and somewhat universal," Fox said. "Because the current validity of valuations is questionable for bank investors, you are seeing bank disclosure evolve."
She added that "investors are demanding more transparency and other measures that may be better indicators of risk."
Pat Jackson, CEO of Sabal Investment Holdings, which was founded following the global financial crisis of 2008-2009 to buy distressed CRE debt from banks, said that pointing to property values based on underwriting from years ago doesn't hold up in the current economic environment. Some lenders will "feel the pain" as they try to offload problem loans, he added.
At some point, Jackson said, "the music stops."
When that happens,
"I think people are underestimating the outcomes on this," Demchak said. "I think people are not taking their loan books down to appraised values and reserving against them. I think there's a long burn."
