It's All Relative in Commercial Finance

A few years back when I was living in the Washington DC area, my wife and I attended a Christmas party for the company she worked for. The CEO of the company proudly announced that his company had grown by over 20% that year. Everybody applauded, and he seemed pleased with himself. But as an analyst, I wondered what exactly he meant.

I turned to my wife and asked, “Does he mean profits increased by 20% or revenue increased by 20%?” My wife just shrugged. The more I thought about it, he could have also meant his balance sheet grew by 20%, or he had secured 20% more contracts to do business. I knew it was a moot point, so I didn’t question it further. But, it exemplifies how information needs context so we can determine how relevant that information is.

J.P. Morgan is one of the biggest banks in the country and has over $2 trillion of assets on their balance sheet. In 2011, the bank had a net profit of $18 billion dollars. It was later discovered in 2012 that the bank had made a hedging error and would be exposed to an $8 billion loss. Reporters and pundits were outraged at the thought of a bank experiencing an $8 billion loss. But, relative to 2011 profits, it wasn’t even half of the profits the bank realized. Despite the loss, J.P. Morgan finished 2012 with a net profit of $20.5 billion. This was equivalent to a return on assets (ROA) of 0.87%, which is relatively normal for a financial institution, and indicates it is likely not under any serious financial distress. An $8 billion loss seems large to us, but relative to a multi-trillion dollar corporation, it is an easily survivable loss.

Common issues with relativity I see on a daily basis have to do with the nature of interest rates and how they reflect risk. All institutions acknowledge that financing construction is more risky than financing an existing building. Often, a person’s intuitive response to this is, “if construction is more risky, then interest rates should be higher than what I charge on an existing building.” This is true, when you are comparing two like projects and terms, but we have to keep in mind an interest rate not only reflects your risk, but also your cost of funding.

When we finance commercial real estate, we typically make a loan for five years that doesn’t fully amortize and has a balloon payment at maturity. Say we make a loan for five years.  Then we will try to find deposits or other funding sources that don’t mature for five years. Our interest rate will be based on the cost of securing that funding for five years. If a five-year deposit costs 1.50%, and we think the risk in the loan is small and only seek a 3.50% margin, then we will price the loan as 1.50% (cost of funds) plus 3.50% (margin for risk) which will equal 5.00% interest rate.

Construction will be funded differently. A construction loan may mature after only one year, and the balance of that loan will be different every month. In this case, we assume each month the loan will be funded at the cost of holding a deposit for one month. One month deposits may have an annual interest rate of 0.05%; therefore, we will change the interest rate on the construction loan, every month, to equal the cost of funds plus some margin for our risk. We know construction is risky, so our margin will be greater than the 3.50% for pre-existing buildings; let’s assume it will be 4.50%. In this case, our interest rate will be calculated as 0.05% (cost of funds) plus 4.50% (margin for risk) which will equal 4.55%.

In the above example, the financing on the permanent building is done at a 5.00% interest rate, but the financing for the construction is done at 4.55%. Why isn’t the interest rate higher on the construction loan? Technically, the return on the construction loan is higher, even though the overall rate is lower. That is because there is a higher margin in the construction loan. The institution will be compensated for more risk, even though the rate is lower. It isn’t necessary to make the construction loan higher than 5.00% to reflect the risk, because the interest rate is also a relative observation. Interest rates are also relative to the cost of funding, not just the risk of the project!