Even if the real estate market is strong, the cause of the non-performing loan status may be directly related to a weak management policy or “home work”. Management can make decisions, which in the short or long term can increase expenses and reduce the level of net operating income, thus increasing default risk on loan’s periodic payments. There can be different reasons for this.
First of all, even if demand will be strong for a longer period in the real estate market, the cause of the non-performing loan may be related to a real estate developer’s weak ” home work”. Excluding “hog cycle” here, developers, who use raw land as collateral, may stand face to face in a situation, where they will not be able to repay a loan. This may occur for the following reasons:
- Poorly done market analysis
- Miscalculations of the effective demand and the competitive supply in the market area
- “Bad” location for particular project
- Wrongly chosen main target group
- Cost overruns and late competitions
- Letting risks and voids
- Miscalculated absorption rates
- High financial gearing of a company
- Weak marketing
- Decreasing population and diminishing export base of local community
Under the circumstances described above, the developer’s income cash flows are arbitrary and prolonged, and income and liabilities do not match. Developer’s default risk is the highest if a building is built for resale without getting a buyer before the project initiation, and if a building is built for lease without getting pre-contracted tenants.
Secondly, every property deteriorates over time.
- Functional deterioration is caused by flaws in the structure, materials or design that diminishes the function, utility, and value of the property. For example outdated design, poorly done “the high and the best use” analysis, inadequate property management diligence, lack of financial support, or any combination of the foregoing may increase vacant tenant spaces as a tenant finds that the property is not suitable for his/her business activities. As the market value of commercial property is directly related to totally leased space and contracts’ conditions, the value of the property as collateral and cash flow are diminishing, thus default risk is higher. Consider, for example, an industrial building that was built in the early 1970’s. The structure’s 3.60 m. ceiling, which was the market standard then, might be considered totally inadequate today when 5 m story heights are the norm.
- Economic deterioration is an impairment of the utility or property due to negative influences outside the property. Because of fixed location, real estate is subject to external influences that cannot be controlled by the property owner, landlord or tenant. Consider a situation, where the property is ready for use in a central business district (CBD) today, but in future it will be located nearby the CBD due to the CBD movement towards more competitive areas. Thus, trough the years the main target group of potential users has been changed, rents and net operating incomes are declined due to changes in the neighbourhood. There is a higher degree of default risk on a loan, especially if the loan is given for long-term. Additionally, cash flows will decrease.
Comparing other reasons for non-performing loans and defaults mentioned above with economic and functional deterioration has a small magnitude of impact to a borrower’s default. Buy CBD UK