Stress Testing

A new residential mortgage stress test is coming. The new qualifying rate will be the greater of the borrower’s contract rate or the weekly median five-year fixed insured mortgage rate from mortgage insurance applications, plus two percentage points.

The current stress test rate is the greater of the borrower’s contract rate or the Bank of Canada five-year benchmark posted mortgage rate. This is based on the posted rates at the six largest banks.

Do these rules apply to Credit Union Commercial Mortgage Lenders?

Are credit union lenders stress testing commercial mortgages? If so, are similar rules in place? Not directly similar to the stress testing referenced above, but more sophisticated credit union lenders have long been stress testing their portfolios. They use tools that assess credit deterioration, pricing risk, industry exposures and overall portfolio performance. Credit union lenders often consider “What If” scenarios as well. Should real estate values decline by 20% across the board, what proportion of loans would be at risk? This would be of increased concern to a lender just new to commercial lending, and one that has done a significant amount of business in the recent past. Loan amortization, in such situations, would be minimal. The portfolio would lack “seasoning” which could weather a market downturn.

Individual Loan Reviews

But what about individual loans? Credit unions typically undertake annual loan reviews. Either on a portfolio wide basis, or on some select sampling basis. An example may be all loans granted in a particular geographic area, or on a particular asset class. Perhaps they are loans exceeding a loan to value of 65% as at the date of approval. Any number of other considerations can be taken into account, including when the loan was last reviewed.

Stress testing is also making its way into the loan approval process at initial underwriting. Approving a loan which has a higher probability of default, may be an appropriate strategy for a credit union. However, they would want to ensure that they understood the likelihood of future problems, and price the risk accordingly.

Prudent underwriting procedures allow credit union lenders to consider debt service ratios, and loan-to-value ratios. However, by their very nature, they are static measures. At best, a snapshot in time. Stress testing at loan approval now often entails consideration of lease roll-over risk. Precisely what effect will the maturing of existing leases have to anticipated property cash flows? Will tenants renew their leases, and if so, at greater or lesser rents. If they do not renew, how long can the space reasonably be expected to be vacant. How does that affect the carrying cost for the owner?

Break-even Rents and Rates

Credit union lenders can also consider both break-even rents and break-even rates. A building may be leased to a variety of tenants, generating a net operating income sufficient to provide a 1.25 times debt service coverage. That is, there is $1.25 of income available to service every $1.00 of debt. However should rents fall, this ratio will diminish. The point at which the ratio is 1:1 is the level of break-even rent. Rents below this level will be insufficient to service the debt. The borrower will need to supplement via other sources.

The corollary to this measure, is the break-even rate. Just as rents can fall, rates can rise. The rate at which the available income can just service the debt, without any surplus, is the break-even rate. A variable rate loan, or loan which is repricing at this higher break-even rate, will at a minimum consequently require additional security or a principal reduction.

Stress testing is part of the toolkit of experienced credit union commercial real estate lenders. Let ACRE Advisory Commercial Real Estate assist you in putting in place the right risk rating methodologies for your commercial lending strategies. Grow your commercial loan portfolio with confidence!