Debt Potential
The approach to the uncertainty attached to cash flows and asset values makes Crucial Analytics a logical tool for exploring the risk attached to the servicing and repayment of debt that uses CRE as collateral.
The safest position for a lender to take is to base a loan entirely on the collateral offered.
The collateral should be able both to service the loan and, at maturity, either to repay it, or to refinance it. This does not require any judgement to be made on a borrower’s ability or inclination to repay a loan, even under adverse conditions. Furthermore, Crucial's analytical approach can be applied to a wide range of revenue streams and asset types.
It is possible for underwriters to seek other assurances from a borrower, but in extreme situations, it is ultimately the collateral alone that will determine the underlying risk to the loan.
CRE-Risk Adjusted LTV and Debt Potential
Basic Assumptions
Any loan offered can be serviced through the net cash flow from the collateral and repaid or refinanced from the asset value at maturity.
These values can be risk adjusted.
Risk attached to either of these factors can have a significant impact on the situation and impose limits on its value as collateral.
All CRE collateral has a ‘risk free’ component (the situation where there is no overlap in the graph shown in the ‘Making Risk Visible’ diagram). This can translate into an LTV which can be offered with no risk to the underwriter. It represents a loan which, over the term of the loan, can be both serviced by the cash flow and repaid by the asset disposal, under any of the conditions considered in the analysis.
Support Fund to Raise LTV
The risk attached to any increase in LTV above the ‘risk-free’ value can be evaluated.
This can be kept in reserve by the borrower as a support fund to cover any negative departures from the expected range of values.
This evaluation and accommodation of risk can allow the removal of LTV and ICR covenants in the facility agreements, as this risk has already been accommodated by the support fund. Punitive LTV and ICR covenants simply render the CRE asset less effective, and more vulnerable to predatory acquisition under difficult situations, by forcing a potentially unreasonable and unnecessary disposal.
It is in the borrowers’ interest to make provision for the risk attached to the loan, as otherwise they place their own assets at risk in the event of default.
Fixed Rate SWAPs
If a fixed rate SWAP is used to repay the loan, then part of the risk (that part attached to the London InterBank Offered Rate (LIBOR)) is directly transferred from the borrower to the lender.
However, the Crucial analysis allows the risk attached to changes in LIBOR, and the risk attached to the collateral performance, to be separated and decoupled.
SWAPs which cover a term greater than that of the loan could, in principle, be transferred to a different borrower or to different collateral. This avoids the need for the SWAP to be crystallised at an unfavourable rate relative to the current reality.
