Stress Testing Development and Construction Loans

By Bryan Slauko, CFA, Managing Director, Base10 Capital Advisors

In today’s market, the most vulnerable sectors that lenders may be exposed to include commercial loans tied to residential land acquisition and development, residential and commercial condominium development and construction, and recreational property development and construction. Many of these projects were financed when consumer demand was much greater and market valuations were significantly higher. Lenders are now facing situations where demand is seriously impaired, valuations are unclear and the path to repayment of these loans is not apparent.

A proactive approach to stress testing these projects is critical and should include a sophisticated financial model that examines risks and financial viability over time. The most important factors that should be tested are those that increase the probability of loss by directly impacting property cash flows and therefore underlying asset values.

These stress factors include:

Declining Demand

In a declining demand situation, the result will typically be longer sell-out periods and/or declines in sales prices. The most relevant stress test is to lengthen the absorption rate and determine how long it will take the project to sell out. Under these conditions, how much inventory will remain for sale at loan maturity? How long will it take for the loan to be paid in full under these conditions? A separate scenario may include both a decline in price and a slower absorption rate. Decreased sales prices will result in lower than anticipated principal paydowns and therefore a longer term to full repayment, and/or residual loan exposure at the end of the project.

Potential Cost Increases

Lenders should also consider whether additional marketing costs may be necessary to more aggressively move product or to support a longer sales period. For projects already in development, what would be the impact of increased labour and material costs? What alternative sources of capital are available to fund any of these cost increases? If the lender needs to advance additional funds to accommodate cost increases, will net sales proceeds be sufficient to repay increased debt levels? In a condominium or recreational property scenario, can cash flow be supplemented by placing some units on the rental market?

Stress Testing Goals

The goal of stress testing is to measure the impact of a range of scenarios on the timing and level of project cash flows and valuation, the primary sources of loan repayment. In all stress testing models, it is critical to run current, best and worst case scenarios to understand the risks involved with alternate potential outcomes. Current scenario assumptions must be supported by documented market data from reliable, independent sources. A proactive approach to stress testing will enable strategic decision making that minimizes risks and maximizes the value of a lender’s initial investment.