Risk Mitigation Isn’t Just For “Risk Managers”
Risk mitigation starts with originations, continues through relationship management and lending, and merely “plays out” if a loan starts going sideways. By then it can be too late …
It’s often been said, “The time between economic recessions in the United States is like a baseball game, one inning for each year.”
Whether you agree or not, it’s hard to argue the current economic recovery has gone into “extra innings” since the Great Recession technically ended in late 2009. That said, despite not just one but two yield curve inversions in 2019 (the classic “canary in the coal mine” for an impending recession), there are many key barometers indicating that the next recession—even if it’s just over the horizon—is not imminent. We continue to enjoy record low unemployment, positive wage and GDP growth, generally modest inflation (occasional spikes driven mostly by higher energy costs), strong housing demand and a record stock market.
So why should we be more vigilant than ever about managing and mitigating risk? Shouldn’t we all be making hay while the sun shines?
Yes, the last 10 years have been great for real estate investors—possibly the best ever. This, in turn, has attracted a lot of smart, innovative capital and new, tech-driven ways of delivering it, making this very much a “borrower’s market” today.
The space has also witnessed a lot of new “efficiencies” that make underwriting, funding and servicing loans easier and more “customer friendly” than ever before. As a result, borrowers—especially those with experience, strong net worth and liquidity—enjoy a variety of attractive, convenient financing options.
The problem is, it’s getting harder to find good deals with viable exit strategies. And no matter how efficient capital markets have become (we’ve already seen several unrated securitizations for REI loans in recent years), demand—and therefore loan liquidity—will always outpace the supply of quality deal flow. The U.S. housing shortage, driven by historically low interest rates coupled with a limited and therefore rising labor and material costs, has been well-publicized. Despite this, other than large “build-to-rent” master-planned communities and other portfolio or “consolidating” transactions, investors and lenders are naturally compelled to take more risk just to generate the same or even lower returns.
All that indicates we’re in a market at or near its peak. The challenges investors face finding good deals combined with an abundance of aggressive (or, shall we say “less than acceptably risk-adjusted”) borrowing options is creating a perfect storm of narrowly profitable deals using higher leverage. All this is a recipe for “significant near-term dislocation.” Risk and reward will always find a way to rebalance, sometimes painfully so.
Risk management (i.e., evaluating and forecasting risk) and developing tactics and strategies to mitigate risk must be everyone’s responsibility. Now more than ever, an ideal risk management culture starts further upstream during general marketing and originations and merely continues through underwriting and the end of the loan lifecycle.
Marketing
Actively manage solicitations and marketing/advertising (human, digital and everything in between) toward the most desirable regions, products or borrower types based on your long-term credit risk strategy. Do not focus on the highest potential immediate volume, lest you’re left “holding the bag” when the music stops.
For example, if you want seasoned borrowers, don’t troll through “expert forums” and platforms where new(er) or lesser experienced investors are more prevalent. Make it clear you value client experience and financial wherewithal., Discourage riskier, less seasoned leads. This sounds easier than it is, for the lure of volume and what appear to be attractive gross yields often result in adverse selection—this is a time-tested truism.
Originations
Despite all that hard work generating new leads, don’t become so committed to “closing the deal” that you avoid red flags or spend too much time trying to fit the proverbial square peg into the round hole. If a deal doesn’t work (i.e., a borrower clearly isn’t qualified, property values look questionable or debt serviceability and recoverability/exit look challenging), it’s better to give a quick “no.”
In that case, either introduce them to another suitable borrower or decline the opportunity outright. Encourage them to keep looking for a better deal and to come back next time. No one likes to waste time and, rest assured, your erstwhile borrower will appreciate your candor and refer you to others who may be a better fit. Being thoughtful and direct “pays it forward” in numerous ways.
Underwriting
Stick to your underwriting standards. Don’t find ways to bend criteria or make exceptions just because you can sell them to your credit committee or financing partners. For example, if you’re traditionally a fix-and-flip lender who lends up to 90% of cost (or 75% of after-repair value) to borrowers with at least three successful transactions at 12% and 2 points, stick with that and focus on delivering a superior, consistent customer experience.
Be responsive and collaborative, suggesting ways borrowers can become more profitable, better project managers or more efficient builders. Really dig into construction budgets to help ensure projects are viable and you are not otherwise funding into a default. Treat the borrower’s precious resources as if they are your own, and help position them for mutual success, even if that means less leverage or occasionally passing on an opportunity. All of this mitigates risk in the long run.
Servicing
Don’t give borrowers a reason—legitimate or not!—to blame you for projects going sideways. Poor loan servicing can often create an unrecoverable downward momentum that will only increase the risk of loss, let alone profits. Rather, help borrowers by promptly responding to requests or funding draws or simply “working with them” as unforeseen circumstances arise.
Don’t burden them with artificial constraints (e.g., sticking to hard-and-fast construction completion dates even in the face of unexpected but understandable delays such as bad contractors and permitting challenges) when sensible flexibility can yield a much better outcome for everyone. Put differently, don’t be a source of frustration for good, honest, proactive borrowers working hard to harvest their investments and pay you back … they’ve got enough to worry about.
If you’ve developed enough confidence to lend in the first place, don’t spite yourself by failing to be “the kind of lender you would want to have.” Some understanding and proactive portfolio management can significantly de-risk a transaction while encouraging repeat business.
The reality is, aggressive or careless lenders who do not stay disciplined and sensible—even at the cost of volume and winning new business—will not find themselves in business for long, especially as the market starts to produce more headwinds, which it always will. So be patient and keep hustling, but stick to your “credit senses” and don’t miss an opportunity to emphasize the importance of practical risk management throughout your organization. Be as flexible and creative as possible, but always look for borrowers and deals with the highest potential for successful exits, even as you are originating them. Even exciting games that go into extra innings will eventually come to an end—and you’ll want to feel good about your team’s effort no matter the outcome.
