The Earnings Squeeze: Can Overlooked Real Estate Assets Balance ROA, Capital & Deposits?
Discover a financial tool that can help your credit union alleviate capital stresses that inhibit growth.
Spring is here, Major League Baseball is in full swing and there’s a corollary for credit unions in the post-COVID business environment. An earnings “squeeze play” is on. The industry remains profitable, but exceptional deposit growth and diminished earnings are squeezing capital. This article discusses the earnings pressures credit unions face, their effect and expected duration and a potentially important financial tool that may well help your credit union alleviate capital stresses that inhibit growth.
Key Financials Metrics In 2020
Across all credit union asset size groups, 2020 imposed a peculiar mix of performance metrics. Deposit growth was impressive at 20.3%. Net interest margin, which had increased in each of the prior seven fiscal years, declined by 34 bps to 2.82%, narrowing the space in which most lending institutions must succeed in order to survive. Declining asset yields significantly outpaced declining cost of funds in an unsustainable race to the bottom. Credit unions responded by cutting operating expenses, which settled at 3.0% at year end; some of the OPEX reductions came from lower credit and debit card expense, which meant corresponding offsets to interchange income. To complicate matters, loan loss provisions were up, jumping to 50 bps, the highest level in a decade as delinquency and charge-offs continued to rise.
(Sources: “NCUA National Trends Report: Credit Union and Corporate Call Report Data, Financial Trends in Federally Insured Credit Unions, December 2020”; “CUNA Industry Economic Outlook 2021.” Federal Reserve references are from the CUNA report.)
The Performance Conundrum
Superior financial performance is driven by an equation requiring adequate earnings to build sufficient capital to support targeted deposit and loan growth – a virtuous cycle that now is largely absent. In the earning squeeze of 2020, that equation had a lopsided shape – deposit growth became the independent variable as members piled far more funds into credit unions than anticipated, exceeding all consensus targets. Earnings weren’t bad; the industry ROA settled at 70 bps. But that was down from 93 bps in 2019 and not sufficient to support historic deposit growth. And so, the industry’s capital to assets position dropped to 10.3% – down from 11.4% in 2019.
Look Forward Prospects
CUNA forecast that 2021 deposit growth will continue to outpace earnings, causing a further capital erosion, possibly to as low as 9.2%. How long can this continue? Fed Chairman Jerome Powell’s most recent congressional testimony put a 2023 date on the end of monetary easing. Fiscal policy will also remain expansionary, perhaps massively so, certainly through the 2022 elections. Combining current emergency fiscal stimulus with pending federal infrastructure legislation will produce further trillion dollar plus deficits. Downward margin compression will almost certainly persist throughout this period.
Moreover, as federal COVID relief unwinds, whether in the form of direct subsidies or delinquency and eviction forbearances, credit union members will face uncertain family finances. That translates into uncertainty about credit union loan loss provisions, almost certainly into 2022. On the plus side, there is increasing evidence that the economy has begun a vigorous recovery. Jobs and incomes will mean an eventual return of consumer lending volume, interchange fee and other non-interest income, and a reduction in credit risks and provision expense. Getting the national economy to and then past pre-COVID breakeven levels is likely to take until at least 2023, as suggested by Chairman Powell’s timeline for monetary policy.
Another relevant unknown will occur in 2023, when credit unions will face mandatory implementation of the CECL loan loss provision accounting methodology. Accountants and consultants are trying to lower expectations of financial statement calamity, but the likelihood is that for the majority of credit unions, loan loss provisions will increase, further compromising stressed capital positions.
An Opportunity to Boost Capital and Support Growth
The earnings squeeze is testing the resilience of management across all asset size groups. Deposit growth is cause for celebration. We don’t want to deter members from building up their deposit balances but we have to find a way to rebuild capital. This situation calls for creative but reliable solutions and we have one to suggest.
Many credit unions have on their balance sheet an overlooked financial resource, namely the unrealized, tax-free appreciation of owned operating real estate. You can tap into that resource through sale and leaseback transactions. A “sale-leaseback” is a proven strategy to enhance your credit union’s financial condition in an operationally seamless manner. While the logic of sale-leasebacks has always been compelling, the new urgency for capital position restoration makes this strategy more effective than ever.
The basic value proposition is simple and time-tested across a variety of industries, including community banks. Many credit unions have operating facilities on their books at steadily depreciating carrying values while those facilities in reality enjoy increasing market values. Thanks to recent changes in accounting rules, by selling one or more operating facilities, your credit union could recognize an immediate tax-free gain, offset COVID-related loan loss provision expense, and generate fresh non-deposit liquidity to invest in member-facing technology as well as in loans to rebuild interest income, all while boosting capital. By leasing back the facility, the credit union maintains uninterrupted operations and control for a lease term negotiated to suit its long term occupancy preferences, typically 20 or more years.
The following illustration depicts a $1.8 billion credit union with 10% capital and a main office building that it acquired 12 years ago with a depreciated book value of $18 million. In this simplified example, the building is sold to generate $34 million in net proceeds that is available to be deployed to loans or investments. The sale generates a $16 million tax-free gain on sales, which translates into a 78 bp boost to capital.
This same scenario applies if your credit union owns much of its branch network, except that the branches could either be sold all at once or in groups, which adds an annuity effect to the financial benefits.
The impact of sale leaseback transactions is synergistic. Your credit union unlocks profit, cash and capital that are otherwise trapped/invisible on its books. You can deploy those resources to support strategic investments and loans to benefit members and communities who are in need like never before. Ownership of the underlying real estate is placed in the hands of an investor who can utilize recently enhanced tax benefits from real estate ownership (including expanded depreciation write-offs and lower effective tax rates) that credit unions are ineligible to recognize because of their not-for-profit status.
The illustration above is simplified for ease of understanding. There are accounting, legal and regulatory issues that require the credit union’s attention, but they are readily manageable.
Ed Lopes is the CEO of CU Real Estate Solutions, LLC (CURES), a Boston-based real estate services and investment company that is focused solely on sale-leasebacks for credit unions.
Steve Eimert is an attorney who has represented credit unions nationwide in a variety of matters, including compliance, CUSOs and executive compensation, and is a co-founder and general counsel of CURES.