If a commercial real estate loan fails to pay on time, what is the probability of bringing the loan current? To answer the question, we looked at 214 loans, originated from 2008 to 2012, to determine the probability.
While more than an academic exercise, the probability distribution helps lenders and managers set strategy and tactics for managing loan problems while providing guidance in setting proper reserve allocations. Further, understanding the drivers of successful workouts will help banks in the future decide on how to manage problem credits.
The odds of bringing a commercial real estate loan that is 31 days delinquent during a downturn are about 35%. Not surprising, every passing day that the loan is delinquent decreases the odds of collections. In fact, the distribution of the probability of collections is a non-linear power curve, which means the probability of collecting money from a delinquent borrower drops dramatically after day 51. Thus, should you get to day 91, the odds of your bank bringing the loan current is less than 3%.
While the above data was largely reflective of a depreciating market, it does give insight into your Bank’s chance to cure a past due loan. To model this probability, the following factors need to be evaluated in order of correlation or influence on the ability for the bank to bring the loan current:
Borrower’s ability to repay – What is the borrower’s financial wherewithal or capacity to affect repayment? The greater the borrower’s assets relative to liabilities, the higher probability of the borrower being able to bring a delinquent loan current.
Borrower’s motivation or willingness to pay – How much of a moral/ethical or
financial incentive does the borrower have to repay? The greater the consequences of non-payment of the loan, the higher the probability of repayment. The greater and the higher probability of loss (be it from the loan’s collateral or reputational), the higher probability of repayment.
Loan documents, underwriting and collections – The quality of loan documents, underwriting, servicing and collections all play a role in predicting repayment probability. In general, the higher quality the loan and collection processes, the less legal room the borrower has to take a stand and the more likely the borrower is to repay.
Economic environment - Unemployment, GDP and earnings all play a role. An improving economic environment creates optimism and improving financial expectations to make the borrower more likely to repay. Sometimes called headline risk, and somewhat anecdotal, the theory is that the more the press is publishing foreclosures because of a deteriorating environment, the higher probability of a default.
State laws – One action, non-recourse, redemption timing and judicial foreclosure states all impact cure rates. In general, the longer and more costly the process the less likely a borrower is to cure.
By understanding the above factors, banks can more accurately predict the chances that a delinquent loan gets brought current and be in a better position to negotiate. The average cost of workout during the time period studied was about 23% of a loans value when all costs were taken into account. This data point, if similar to your bank, gives lenders a clear framework about not only when and how to negotiate, but a range of values by taking the past due amount, the probability of cure and the cost of foreclosure.