Over the past five years, First Republic Bank (NYSE:FRC) has beaten the KBW Bank Index by 30%. Since 2011, the bank has beaten the S&P 500 by a solid 11%. Those kinds of results get my attention. And the first step to finding out what's driving them is to learn how exactly this bank makes its money.
How First Republic Bank makes its money
First Republic is a pretty simple bank with a modern twist. At its core, the bank accepts deposits, originates loans, and helps its clients with the financial management of their lives and businesses.
So what's the twist? Instead of building out an expansive branch network and basing its business on geography, First Republic opens offices in strategic locations targeting affluent individuals in major U.S. markets. The bank has only 71 offices -- a tiny number, considering it has more than $46 billion in total assets.
These individuals are of high net worth, and oftentimes they own businesses. First Republic seeks to attract and retain these customers with world-class customer service tailored to the needs of the wealthy.
The result is an excellent mix of income from lending and from low-risk non-lending businesses.
Breaking down income from lending
First Republic's primary product is the mortgage loan. Given First Republic's more affluent customer base, these loans have, on average, much lower risk profiles than the mortgage loans made at other institutions.
For example, the average loan-to-value ratio of new single-family loans originated in the third quarter was just 60%. For many banks, that number exceeds 80%. A lower loan-to-value means the bank has more buffer from losses if the loan goes bad, and it also means the homeowner has more skin in the game.
A full 55% of the bank's loans are secured by one- to four-family real estate. The second-highest concentration of loans are secured by multifamily residential properties, at 12% of total loans.
That mix of loans generated total interest income of $378 million in the third quarter, according to the bank's most recent quarterly filing with the FDIC. Interest expense was just over $40 million, resulting in net interest income of $338 million for the quarter.
That net interest income represents 81% of the bank's total income. Let's tackle the other 19% next.
First Republic's non-interest income
Based on the high concentration of lending income relative to total income, it's clear that First Republic's bread and butter is lending money. But the bank does supplement that with non-lending activities.
For the third quarter, the bank reported a total of $79 million in non-interest income, driven primarily by income defined by the FDIC as "investment banking."
To be clear, First Republic is not an investment bank like you may have seen on The Wolf of Wall Street. First Republic simply categorizes the income it makes from its financial advisory, trust, and wealth management businesses as "investment income" per the FDIC's definition.
Here's the full breakdown of non-interest income from the third quarter:
The "asset sales" category is the accounting used to capture the sale of mortgages into secondary markets. This is a normal course of business for First Republic; however, the third-quarter sale was the largest in the bank's history. That speaks to the bank's growth and its fundamental operating strength.
What you get when you own First Republic Bank
This exercise in breaking down First Republic's income streams gives us a clear picture of exactly what this bank is -- and, even more importantly, what the bank is not.
The bank is, at its heart, a mortgage lender. Those mortgages are exceptional in their quality. The bank's other loans are diversified and are most often complimentary products used to increase wallet share among the bank's affluent customer base. The bank supplements its lending business with non-interest income, primarily from trust and wealth management fees.
This bank doesn't rely on market making, private equity, or hedge funds. It's not a player in the proprietary trading business. It is most certainly not interested in subprime lending.
When you add it all up, First Republic has a pretty solid profile. The bank makes its money with a conservative approach, an easy-to-understand business model, and a commitment to prudent risk-management.