Advising Your Borrowers to Refinance with Ed Kofman

Caleb Stevens:
All right. Well, Ed, welcome back to the Community Bank podcast. How are things out in San Francisco?

ed kofman:
Thanks for having me. It’s beautiful out here. It’s cool and dry and there’s no rain in the forecast, so it’s beautiful.

Caleb Stevens:
Isn’t it a Mark Twain quote where he says, the coldest winter I ever spent was a summer in San Francisco? Isn’t that a quote?

ed kofman:
That’s why we love it out here. It’s cool in the summer and warmer in the winter. Mediterranean

Caleb Stevens:
Yeah.

ed kofman:
climate.

Caleb Stevens:
Well, it’s good to be talking with you again. I want to dive into getting your thoughts just on what you’re seeing on the lending side of things. We have a lot of commercial lenders that listen to this podcast, probably several lenders that use the ARC program and appreciate everything that you do to help their banks win more loans and generate fee income. But I’d love to just start with, you know, tell me about just in general, some of the CRE. lending trends that you’re seeing. You know, we’re hearing in the news about office loans potentially being a hazard in the future. What’s sort of your temperature check on the state of CRE lending?

ed kofman:
Well, so there are a couple of categories in CRE that are going to face challenges. One is larger retail, so model space. Definitely, it’s asset class that has less demand. It’s harder to reposition. But, you know, frankly, community banks were not active in that particular sub-segment of the market. So I didn’t see… Yeah, we… I’ve seen some community banks finance smalls, but it wasn’t a mainstay of our business on the ARC desk. And it’s not something that many community banks do in the first place. But you know, that was a asset class that deteriorated before the pandemic. I think it accelerated with the pandemic. The other subsegment is larger office. And again, the pandemic accelerated the… work from home mentality, it’s not coming back, especially in certain cities. So if you’re in LA, San Francisco, Chicago, office space, especially larger footprints that have a harder time to be transitioned. Again, that’s gonna be a challenge for some of the lenders and the REITs. You know, many of our clients, our community banks, we’re not large lenders in that space either. And the few banks in San Francisco, Los Angeles, They’ve been tepid in that market, but there are going to be challenges for that. But if you know other segments like hospitality, industrial, self-storage, multifamily, that continues to have good performance and default rates are relatively flat. Of course that may change, but one thing we need to consider, despite the fact that rates have gone up, there’s a tremendous amount of liquidity. in the market continues to be drained. Banks are facing pressure on funding, but there’s been enough out there, both in owner equity, owner liquidity, and enough dry powder at national, regional community banks, there’s still enough supply for refinancing. So this is not what we saw in 2008. It’s a different story. It’s a slower developing story. But as long as the economy is healthy, we have employment, there’s enough liquidity, I don’t see a wreck on a fast pace. There’s going to be changes, but it’s slow moving.

Caleb Stevens:
Yeah. Well, as rates have gone up over the past few years, I think it’s fair to say that many borrowers have experienced sticker shock. Prime was at 3% just a couple of years ago, and here we are at 8.25%, something like that. And I think there’s probably a temptation for those borrowers to want to go ahead and park their loans into shorter term facilities. You see this as a good thing for banks, is this a bad thing for banks? If I’m you know, a bank management team, how should I be thinking about the sticker shock that my customers are experiencing and how to help them think through, you know, their financing needs.

ed kofman:
Well, there’s a whole bunch of questions there. Let me decipher it. So first, I wanna mention that every borrower that I ever have spoken to believes that his or her rate is too high. I’ve never seen it the other way. So obviously you’re talking to a one-sided market that believes they should get capital cheaper, number one. Number two, sophisticated borrowers and most lenders should recognize that the true cost of debt carry the cost of paying interest. So it’s not P&I because principal is return of what you borrowed, but the carrying cost of debt is not the nominal rate, it’s not the interest coupon you pay, it’s the real interest rate you’re paying, which is nominal minus inflation. So when you look at it that way, because inflation has gone up, rates haven’t gone up as much as inflation has from 2021. So the actual cost for debt hasn’t increased. In fact, there’s an argument, depending where you are in the term structure, that it’s actually decreased. The real cost of carrying debt has actually gone down. And it’s easy to show mathematically, but it’s simple addition and subtraction. If inflation is 10% and your interest rate on your loan is five, you’re getting paid 5% to pay that loan back. That’s just the reality. So rates haven’t gone up on a real sense, they have nominally, but economically they haven’t gone up. So that’s an important thing for lenders to point out to clients. It’s still an opportune time to finance projects that have any real return. And if a project doesn’t have a real return, really there’s no reason. to have senior secured debt on that project. So that’s very important. You mentioned that. The other point that you noted is, is this the right time to refinance? We get a lot of borrowers questioning the right time to enter the market for refinancing. And it’s very much like finding the entry point on the equity market, it’s impossible. You just don’t know, no one can predict. the future price of any financial instrument, whether it’s Apple stock or the 10 year treasury. So it, putting something off in the future carries an inherent risk. And the risk is this, borrowers say, well, I’m gonna wait until rates come down. What’s gonna cause rates to come down? Well, it’s going to be the Federal Reserve decreasing short-term rates. When would the Federal Reserve do that? Well, with the economy struggling, if the economy is struggling, spreads widen and liquidity dries up. And so the availability of credit may not be there. Never mind that the business model for the borrower may not be sustainable in the downturn. No borrower ever wants to admit that in a recession, they may not be able to carry the load on that loan. So.

Caleb Stevens:
Right.

ed kofman:
Waiting for a recession to refinance is never a good time, never a good strategy. Right now, it’s a pivot point because borrowers remember 2022, 2021 with the pandemic and rates coming down. But if you’re hoping for another pandemic to lift your business because your loan payments are going to be lower, you may be waiting 100 years and it may not be the opportune time. The government may not be flooding the market with liquidity like it did a couple of years ago. So now is a good time with inflation where spreads are. And something else I wanna point out. Even though banks are less likely to lend today, credit spreads are actually tightening because banks are looking for higher credit quality deals, relationship deals, and when that happens, they’re competing for better business, and better business is won with lower credit spreads. So any borrower that’s looking to refinance, not a bad time. When you adjust for inflation, when you look where credit spreads are, it’s a pretty good time for borrowers to refinance their debt.

Caleb Stevens:
Well, and it reminds me of what you said a while back on one of our video resources. You said that, you know, as lenders, you’re not just in the business of making loans, you’re also in the business of keeping loans, and many of the most profitable customers that you could attain are already on your books. Could you kind of unpack what you mean by that?

ed kofman:
Caleb, you’re breaking up. Can you hear me okay? Because you’re starting and stopping on audio.

Caleb Stevens:
Sorry, can you hear me now?

ed kofman:
Yeah, I can hear you now. Try

Caleb Stevens:
Okay,

ed kofman:
that

Caleb Stevens:
I’m

ed kofman:
again.

Caleb Stevens:
gonna turn off- I’m gonna turn off my camera to save some bandwidth. Maybe you can kill your camera too.

ed kofman:
Okay. Kill my camera? Okay. Just a second. Okay.

Caleb Stevens:
Alright, that should

ed kofman:
How was

Caleb Stevens:
help.

ed kofman:
that?

Caleb Stevens:
I’m gonna re- That should help. I’m gonna re-ask the question and we can just keep moving. All right. Well, it reminds me of what you said a while back in one of our video resources. You said that, you know, as lenders, you’re not just in the business of making loans. You’re also in the business of keeping loans. In many cases, your most profitable customers may already be on your books. Could you unpack what you mean by that?

ed kofman:
Yeah, so there are two important facets of that statement. The first and simple one is that everyone talks about a relationship, you want relationships. What does that mean? Why are relationships important? So one major reason why relationships are important is because every time you bring in a new relationship to the bank, new business, it’s expensive to source it, underwrite it. get approval, document it, board it, and fund it. It’s a lot cheaper just to do a renewal or to upsize an existing credit facility or retain what you have through an annual review as an example. So the average commercial loan for the average bank, brand new loan, anywhere from four to 8,000 depending how efficient the bank is. to renew that same credit, depending again how efficient the bank is and the complexity of the loan, anywhere between $1500 and $3000. So if you’re thinking about why it’s important to have relationships, they’re a lot more profitable because they’re cheaper to maintain. So if you were to have the same relationship for the next 10 years rather than putting 10 new clients every year, the same relationship is a lot more profitable for you. Okay, so that’s one reason. The other reason is that every bank says they want a relationship, but when you look at the prepayment speeds on loans at average community banks, again, depending on the bank, the type of loan, where we are in the business cycle, where rates are, but the average bank sheds or churns through 35% of its loan portfolio. So 35% of the loans prepay. Well- lenders don’t want to see a shrinking portfolio, in order to maintain that business, you have to go and find new credits. Well, if you can keep that prepayment speed lower than 35%, you’re that much further ahead, okay? Number one, and in that same vein, number two, if you rank your profitability from the most profitable client to the least profitable. you’ll see that some of your most profitable clients have been there longer, their longer term relationships. So you’ve maintained the relationship longer, you know the credit better, you’ve been able to cross sell more, you’ve seen their repayment history through a downturn. So it’s a better credit quality, higher ROE. If you can keep those credits, if you know what they are, you can keep those and then try to shed. If you’re gonna have a 25% or 30 or 35 prepayment speed, try to get your least profitable clients to walk out the door. You can improve the bank’s total ROE substantially by not really bringing in many new accounts into the bank. So you’re not expending a lot of marketing dollars, underwriting dollars, funding dollars. All you’re doing is redistributing your portfolio, keeping your most profitable long-term relationships, making sure they don’t go anywhere. And then either showing your least profitable relationships the door, but you do it politically correct, or you try to cross-sell to them, increase profitability on those. And so it’s very important to understand Making loans is very expensive. It drains capital and reduces ROE. It’s the relationship side, keeping

Caleb Stevens:
Thanks

ed kofman:
loans

Caleb Stevens:
for watching!

ed kofman:
as long as you can. And it’s a little bit like a marriage. So it’s a two-way street. It could be very painful if the client is unprofitable for the bank, but it could be extremely fruitful for the bank if the client is profitable and you can extend that relationship over a longer period. So that’s what I mean. by that state.

Caleb Stevens:
And along those lines, you’ve also really emphasized, I know in the past, the importance of borrowers having liabilities, i.e. loans, that mirror the assets they’re looking to finance. Talk about why that matters in this conversation around refinancing.

ed kofman:
Yes, so I think that the upper echelon of a lender as a trusted advisor is the ability of a lender to truly understand both the psychological position of the borrower, which is not your question, and then also the financial position of the borrower. And so the financial position of the borrower is the root of your question, and that is what makes sense for the borrower’s balance sheet. How should the borrower try to structure the balance sheet to weigh assets and liabilities and manage cash flows? So for example, if the borrower has the ability to increase revenue, EBITDA, or NOI, in a rising interest rate environment, And conversely, if their revenue, EBITDA or NOI comes down in a decreasing interest rate environment, then their business is sensitive to interest rate movement, right? So they follow rates up and down. That type of borrower is better suited for floating rate loans because it produces more stability for their cash flow. On the other hand. and this would fit many real estate projects that don’t reprice with interest rates. And in fact, the value of real estate is inversely correlated to rate movement. But let’s take another category of real estate. Let’s take multifamily, where some units reprice every year and some cannot reprice. And if they do, it’s set to a maximum repricing. then that type of project, the NOI doesn’t go up when rates go up. And there the borrower is better suited to protect their NOI with a fixed rate loan. Because you don’t want to see a mismatch between the NOI that the project generates and the P&I payment that the borrower makes. So there you want to stabilize the borrower’s debt service coverage ratio, which by the way is what we all underrate. Right, so what is the debt yield, the LTV, and most importantly, what’s my debt service coverage ratio? How much room do I have? Well, if rates go up and you put that borrower into a floating rate loan, their cost of carrying the loan goes up, but their revenue doesn’t go up, their NOI doesn’t go up, all of a sudden you have a mismatch.

Caleb Stevens:
Right.

ed kofman:
Not only is it bad for the borrower, but it’s bad for the bank, because now you have potentially a non-performing loan. A borrower that cannot make their P&I payment and you’ve got a restructure and it’s a TDR. So it behooves bankers to understand the client’s business model and review it. And most of us are guilty of it. Most of us only look at three-year historical. Well, over three years, depending on the timeframe you’re looking at, interest rates may not have moved or they may have moved in only one direction. And what you want to see is how the business reacts to rates going up or down. So you need to go back over a longer period. Now, if you can’t do it for that business, that’s okay because most categories, so if your borrower is operating, multifamily, industrial, pizza parlor, you know, a florist shop, whatever they’re doing, you could look at the proxy for the industry. And that can give you a very good idea of how sensitive that business is to interest rate movements and you can underwrite that.

Caleb Stevens:
Yeah, well, talk about how the inverted yield curve relates to all of this, because typically banks think of an inverted yield curve as a bad thing. You know, typically we hear in the news cycle, oh, the curve’s inverted. That means bad news could be on the horizon for the economy. But talk about, I mean, are there any opportunities that an inverted yield curve make possible for banks right now?

ed kofman:
So, yeah, two problems on that. The inverted yield curve portends, typically, lower rates in the future. It’s an estimate of what rates are gonna be in the future. The forward curve is always wrong. We just don’t know which side it’s wrong on. If it’s too high or too low, we just have no idea. It’s the market’s best guess, and the market is guessing with billions and trillions of dollars in future contracts and forward rates. But we are witnessing an unusual recovery from a pandemic where the market was flooded with a tremendous amount of liquidity that is now being slowly drained out of the market. So that partly explains what’s happening with the yield curve. Now as far as challenges and opportunities, if you are a bank and you’re putting on your fixed rate loans, which most borrowers don’t want floating rate loans, they want some certainty. So you’re naturally being selected by borrowers who say they want three, five, seven, ten year fixed rate loans. You’ve got a challenge because that fixed rate is lower potentially than the front end of the curve. And it could be lower than your incremental cost of funding. So if you’re putting on fixed rate loans to quality clients to reach a 15% ROE, if you do the backward math on loan pricing, Rayrock, you’re at six, six and a half percent in today’s market. You know, that could be higher than your cost of funding, but not that much higher. So there’s a real challenge. today in an inverted yield curve environment can use a hedging program, loan hedging program, have a tremendous advantage in the following way. They can offer the borrower longer term fix get the borrower a lower fixed rate, but earn themselves for the bank yield a floating rate, which is 150 to 200 base points higher than what the borrower’s paying. So I’ll say that again. So

Caleb Stevens:
Mm.

ed kofman:
through the hedging program, a bank can earn a substantial premium and net interest margin. Not even the, so that, it stands on its own. But additionally, that same institution using a hedging program can one, reduce its interest rate risk, two, generate additional fee income, three, market a product that is now indifferent to rate risk. So you could show the client a seven year or 10 year. If you can underwrite 15 or 20, now you’ve got a competitive advantage because you’re showing a differentiated product. And some bankers will say, well, hold on. But the yield curve is predicting that your rate’s gonna come down. So the answer is yes, that’s a prediction. We don’t know what rates are gonna do. But naturally, a commercial borrower that takes a 10-year deal is not going to keep it for the full 10 years. We know that. So at some point, you’re five, six, seven, they’re gonna come back and they’re gonna say, I’m selling that property. or I’m doing an amendment or I need to refinance and there’s an opportunity for the bank to reprice again to include additional fee income and revisit the structure. So now is a perfect opportunity for banks that haven’t yet considered a loan hedging program to incorporate it because you get immediate boost to net interest margin, fee income generation, protection of your balance sheet, differentiated product. and it’s something they can keep on giving to the bank if you structure it correctly for a relationship account. If it’s a transaction, doesn’t work as well. At South State, we do this loan hedging program, ARC, for relationship clients, we wanna grow that business, we wanna retain it for long term. If it’s a borrower that you think is coming through. revolving door in for one year and out the next, it’s not the right choice. It’s not suitable.

Caleb Stevens:
Yeah, and I think that’s what makes the program unique is that it really does help banks maintain a long-term profitable relationship with commercial borrowers while giving the commercial borrowers the simplicity they need, the solution they need to have a long-term fixed rate loan for the borrowers who need that. As we wrap up, Ed, talk about this free ebook that we have for our listeners to help them just better think through refinancing strategies and potential ways that they can leverage. our hedging program here at South State.

ed kofman:
Yeah, so, you know, the national banks have different models, presentations, courses, to try to instill discipline on their lenders, on their commercial teams, on when it makes sense to refinance. So it’s dependent on time remaining to maturity. So if you have a five-year credit facility and there are only three months left, you’re in panic mode, you need to refinance that because a month from now if there’s some event, credit event, you know, if there’s another bank failure and your institution doesn’t wanna lend, you’ve got a liquidity crunch as a borrower. So how much time do you have left on your credit facility? What rate do you have on your credit facility? Obviously, if it’s a 2% rate, you want to write it out as long as you can. You know, how is your

Caleb Stevens:
It

ed kofman:
business performing relative to when you were underwritten? So if you have your credit facility when you were a startup five years ago, and now you have a proven history and a record, you’re probably a good candidate to refinance at a lower credit spread because you’re a lower credit risk. Then we look at what are you going to get into? What’s the commitment? What’s the am term? What’s the commitment term? What’s the structure? Is it a portable facility? Does it have pricing tier based on your performance? These are a lot of pieces that could fit together and borrowers don’t have the sophistication to be able to do the analysis. Many borrowers get their best advice at a cocktail party talking to another borrower at their industry. at a trade show. And it may not be the best advice for them. So it’s important for our industry to have lenders that are trusted advisors who understand how to look at all those pieces and then present a cogent argument for the borrower saying, hey, you should refinance now or you shouldn’t. You should wait for these following things to occur. For example, you had a bad year last year, let’s see how the next 12 months go, and you have four years left in your credit facility, and you’re paying 3.5%. Doesn’t make any sense to refinance now. So we have an ebook that distills all that information. And we have some other materials on top of that that are not part of the ebook, like in some Excel files that lenders could use. But it’s good for lenders to take a look at this. to brush up on their skills, bring it up internally with their management team and say, hey, do we have a model internally? We have a framework of how we approach our best clients, talk about refinancing their existing credit facilities. Because if you do not approach your client and they are a quality borrower. rest assured your competition is approaching them. And if they’re approaching them, you don’t want to be reactive because in a reactive scenario, you’re always winning by showing the lowest price or the loosest credit structure. And that’s not where banks want to compete. So you wanna be proactive. You wanna refinance that client into a new 10-year facility. so that when B of A or Wells Fargo calls on them, you know, they’ll say, you know what, you’re too late. I just got my loan renewed at this community bank. They gave me a 10 year rate, great rate, and I can carry it over from property to property. And I love their service. And they were the first ones to show me this option. And I already did what they advised me to do.

Caleb Stevens:
Well folks, to go and get that ebook, all you have to do is click the link in the show notes of this podcast episode, or you can go to southstatecorrespondent.com forward slash ebook. That’s southstatecorrespondent.com forward slash ebook. We want to help you and your lenders be equipped to navigate your borrowers through the coming years. Ed, thanks for your time. Always enjoy catching up. If folks want to learn more about the ARC program or get in touch with you, how can they do that?

ed kofman:
The easiest way they can contact us at arc at SouthStateBank.com and we’d be happy to show them how we use this arc program at our own bank at South State.

Caleb Stevens:
Fantastic. Go ahead. Thanks for the time. I always enjoy the discussion.

ed kofman:
Thanks, Caleb. Take care.