As commercial real estate loan production grows ever more specialized, small banks are increasingly finding themselves on the wrong side of the competitive fence. Frequently, they lack the top talent, processing systems and operating protocols to effectively compete with dominant niche players.
Although there is an abundance of small banks that have successfully amassed a very loyal customer base, allowing them to prosper over the short term, many ultimately hit an organic wall. Over time, small banks typically confront a situation where additional loan growth becomes highly problematic.
A combination of government regulations along with clients' increasing appetite for larger and larger credit facilities ultimately outstrips a small bank's ability to perform. Deposits can creep away as clients migrate to regional, super-regional and national banks in search of more diverse and deeper product offerings.
Aside from packing up their marbles and heading home, what are the small banks to do in the face of specialized lenders that can offer lower rates, more diverse products, and virtually unrestricted lending limits?
In the case of multifamily lending a handful of lenders, most notably LaSalle Bank's Multifamily Finance Group (formerly known as InterFirst Apartment Lending), Washington Mutual and Citi, have emerged to dominate this niche on a national basis. Collectively these three firms have a 40%-plus market share on a national basis and upwards of 70% on both the East and West coasts.
By partnering with one of these giants, small banks can widen their product base and retain clients. Partnering can take many forms. It can be a simple referral, wherein there is no benefit for the sourcing institution aside from the kudos achieved by being a resource to their clientele. Although providing a client with industry knowledge is good citizenship, it ultimately is not sustainable.
Rather, referrals typically are geared to generating the holy grail of the banking world, namely non-interest income. Non-interest income is simply revenue or fee income that is garnered without the deployment of capital.
Big or small, the key measures of success across the banking industry are return on assets and return on equity, and nothing juices these measures like non-interest income. To achieve this goal, banks must generate income without deploying their assets. Larger banks are able to do this by securitizing their loans, but smaller banks don't have the same access to the capital markets and must take equally creative steps to generate non-interest income.
Faced with losing a customer because they are unable to meet their credit needs, smaller banks have two choices. The first option is to simply broker the particular deal to a lender that has an appropriate product offering, say a 10-year, fixed-rate term loan with low going-in costs.
The second option is to “table fund” the loan in their name, sustaining the appearance of control to their client base. Table funding entails the simultaneous closing and purchase of a loan such that the lender of record does not actually fund the loan. Instead, it is the buyer of the loan that acts as the true funding source.
When table funding a loan, a smaller bank typically needs to offer “reps and warranties” to a larger lender. In other words, it assures the purchaser of the loan that the proper due diligence has been completed. Table funding enables the smaller bank to maintain the appearance of a robust arsenal of products, while using the balance sheet of its funding partner.
Arguably there is a degree of verisimilitude to this arrangement, but at the end of the day all parties have achieved their goals. The longstanding customer of the small bank has had its credit needs fulfilled, while the small bank has retained its client and in the process generated non-interest income. At the same time, the larger bank has sourced a ready-made loan that is backed by a contractual scope of diligence from it small-bank partner.
Importance of Interconnectivity
Many of the larger lenders' product specializations extend well beyond just real estate offerings. In the case of LaSalle, the bank is also highly active in providing operating lines of credit to smaller financial institutions. When this is the case, the scope of interconnectivity determines how LaSalle prices such lines. Clearly the profitability of referred real estate loans has a bearing on the overall relationship in much the same way that offsetting balances factor into a more traditional banking arrangement.
When this last piece of the puzzle is factored in, it is not hard to see that small banks with an eye toward their long-term prosperity benefit from interconnectivity with their larger peers who are capable of offering specialized products that dominate niches such as multifamily lending.
Charles Krawitz is the national director of the Multifamily Finance Group at LaSalle Bank.