The Role of Commercial Bank in Real Estate Finance
Real estate financing is the provision of finance or capital for housing purchase or building. Real estate finance also means the capital required for construction of housing or the resources required to acquire or access housing project by household or the credit supplied by housing finance institutions against some collateral (Dymski, 2007). Real estate finance loans are generally structured as long-term loans, the periodic payments for which are similar to an annuity and calculated according to the time value of money formula. The most basic arrangement would require a fixed monthly payment over a period of ten to thirty years depending on the conditions of the agreement. Over this period, the principal component of the loan would be slowly paid down through amortization. In practice, many variants are possible and common worldwide and within each country (Tse, 2002).
Commercial banks play a crucial role in the economic resource allocation of countries by basically channeling funds from depositors to investors continuously (Ongore&Kusa, 2013). They offer all important services of providing deposit and loan facilities for personal and corporate customers, making credit and liquidity available in adverse market conditions, and providing access to the nation’s payments systems (Handley-Schachler et al., 2007). Commercial banks make most of their money from lending to their customers in various forms.
The soundness of the banks to a larger extent depends on their financial performance which indicates the strength and weakness of a particular bank (Makkar& Singh, 2013). Financial performance is evaluated by the profitability. Real estate financing is an important line of business for the banking industry, and real estate financing activities contribute significantly to the Nigerian economy. Most of the commercial banks rely on revenue from this line of business to grow and prosper (Bienert, 2006). History has shown, however, that imprudent risk taking and inadequate risk management, particularly during periods of rapid economic growth, can lead to significant losses and be a major impediment to the performance of commercial banks with risks of failure very high. One of the major ways in which this line of business influences the performance of commercial banks is through the cyclical nature of real estate markets where, as markets peak and decline, banks with large concentrations of real estate loans may suffer considerable losses leading to poor financial performance (Kibirige, 2006).
It is generally observed that commercial banks’ lending criteria are pro-cyclical in nature. This means that their lending criteria are not very strict in a real estate boom while during the bust they are very strict. As a result of this, commercial banks are more likely to underestimate the default risk of real estate loans during a real estate boom. Such a situation leads to real estate price inflation and this increases the banks’ credit risk exposure to the real estate (Macharia, 2013). When there is a sharp drop in real estate prices, commercial banks that have a high proportion of real estate loans in their portfolios or loans to other financial institutions that specialize in real estate lending suddenly find themselves faced by a high exposure to real estate risk. This therefore affects their financial performance in a significant manner. As a result, the country's financial system becomes risk and exposed (Macit, 2011).
Nigeria has a large housing gap which is growing every year and is increasingly prevalent in urban areas due to differences in income levels in the economy. Macharia (2013) indicated that low interest rate schemes in commercial banks made between 2001 to 2004 made a positive impact on the credit growth of mortgage finance loans from loan takeovers from existing lenders. While Nigeria mortgage market is growing, the industry is dominated by the big commercial banks indicating barriers to entry or high risk for medium and smaller banks.
The most economical source of borrowed capital available to Real estate is commercial banks (Nwoye, 2008). It is not debatable that the commercial banks form the largest source of funding for real estate. Because of the nature of funds available to them, commercial banks specialize in the short term lending and working capital funding in form of overdraft. Before a loan is granted the bank requires a well formulated business proposal to convince them as to financial needs of the business and how the loans can be serviced and repaid if granted. The purpose of borrowing determines the type of loan to be granted. If the potential borrowing is a credit risk, or if the amount of fund being applied for exceeds the amount that the bank manager considers reasonable on unsecure basis, then security is required.
Commercial Banks specialize in short term lending, this is because most commercial banks’ deposits are subject to withdrawal on demand by the customers and therefore should be risky to lend out for a very long term or permanent financing. Most commercial banks’ interest on loans depends upon the level of interest rate in the economy, usually determined by the central Bank. However, in 2007, the Central Bank’s controls on interest rate were removed by the Federal government in line with emphasis on deregulation of the economy (CBN Annual Report, 2007). It is clear that commercial loans, equipment financing and leasing are the most common and are for short-term seasonal needs. They mature 90-180 days and they may not be backed with collateral.
Term loans normally are loans which are paid within 5years and are secured. The principal amount is paid instalmentally and the business must abide by certain stipulated conditions entered in the loan agreement. With equipment financing and leasing, banks will loan on equipment as collateral and can arrange for small business to lease equipment for negotiated periods of time. Bank loans can be for short, medium and long terms.
Banks use the following criteria in evaluating requests for loans, character, capacity, capital, condition and collateral. Character is associated with the reputation which is a sum of personal attributes revealed indirectly. A borrowers’ reputation is really the opinion held by others about him. His business conduct such as prompt payment of obligations and speculative tendencies are all manifested by his character. To banks, character means the ability of a borrower to conserve the assets of his business and to ensure prompt repayment of his loans. Character is therefore very important in the evaluation of credit worthiness of business and individuals.
Capacity narrowly means the ability of a borrower to pay his monetary obligations when they fall due. The borrower, in addition to being capable must also be willing to upset his liabilities. The customers’ net worth in the business assures the bank that the borrower will be able to meet his obligations. Borrowers should have strong capital base. Banks prefer to collect back their loans from anticipated income or profit rather than from the proceeds of liquidities pledged collateral.
Some factors over which the small businessman has no control may inhibit the granting of bank loans to him. Seasonal characters of the business, long run business activities are some of the inhibiting factors. New businessmen must provide collateral for bank loans. Old timers with high credit standing do not necessarily secure loans. Property, life insurance policy and marketable securities are among the collateral provided. There is a greater risk in expanding business, hence long term loans have to be protected by directly pledging assets.
Lipsey (2003) observes that commercial banks in Nigeria could not significantly contribute to the development of small business because of the low rate of returns of entrepreneurial development. The cash holdings of the commercial banks are mostly made up of demand deposits. These deposits are liabilities to the banks and are payable on demand. Thus, short term loans, cash and advances are the major consumers of commercial bank funds in this country. Many projects are financed by commercial banks, which include ventures such as flour milling and bakeries, footwear’s printing and publishing, soap, oils and detergents. The banks hardly finance projects requiring medium and long term loans because current deposits constitute their main source of funds. This was confirmed in the study carried out by Manufacturers’ Association of Nigeria (MAN) in a survey aimed at determining funding requirement of the manufacturing se ctor as well as existing constraints in accessing bank credit. It revealed the nature of banks operating in Nigeria favors short term credit financing as against medium to long term financing (SMEDAN, 2007).