Commercial Lending Capital

Twenty year olds making $50,000 per month was commonplace and the parties were outstanding!

Each day we (all of us including Commercial Lending Capital) are confronted with questions and issues regarding the valuation of real estate and what it all means to the value of the loans that we are able to issue. GONE are the days when an investor could whimsically hand over suitcases full of cash for borrowers that in hindsight had no intention of repaying their loans. Also gone from the repertoire of commercial underwriters is the ability to depart from tried and true underwriting guidelines; in other words welcome back to the good old days.

Instead of crying to the heavens in the name of an individual’s god, as many have been doing, it seems to make more sense to understand the issues behind commercial real estate valuation as it is currently confronting us. When Commercial Lending Capital evaluates a loan proposal we also are confronted with the issue of what a property might be worth. Unfortunately unless an individual with adequate training and experience and with the correct data set is standing in front of the collateral then it is very difficult to understand what the true nature of the three approaches to value might be. Commercial Lending Capital has recently adopted a four approach method so as to minimize the client’s expenditure on appraisal activities. It has been said that any 10 similarly trained appraisers sitting in the same room with the same data and using the same brand of calculator could come up with 10 opinions of value. The one thing that I know for certain is that although the values may differ from one another the differences mainly involves semantics. In other words Appraiser’s, especially in the commercial arena, have been found to be extraordinarily accurate in their assessments due to the amount of research that they must conduct to arrive at the valuation. Brokers will frequently vehemently disagree with this position but I stand by it.

The economic downturn is reducing demand for commercial real estate, and vacancies are expected to rise sharply (and have done so). Investors are facing higher borrowing costs and have access to less leverage, which negatively impacts values. Leverage is one of the prime motivators for investors to purchase real estate. To start, it allows investors to control a larger property than they otherwise could if they had to pay all cash, thus increasing their return on equity. Leverage also allows investors to spread their equity across multiple properties, minimizing their risk through diversification.

Here is the problem: when there is uncertainty in the markets (some say panic), lenders hedge their risk by building in greater cushion in their underwriting, including increasing 1.) Debt Service Coverage Ratio (DSCR) requirements, (2) much wider loan spreads, (3) and decreasing Loan-to-Values (LTVs). Brokers on the other hand have also panicked and have artificially (some say fraudulently) increased income and values on loan applications because they are rolling back to the 2006 stigma when it was considered commonplace to do so due to the stated loan phenomenon. Guess who suffered? The Broker got paid but the investors and lenders are still holding the bag on loans that went south because the level of due diligence was inadequate. Even the Correspondent lenders got caught by surprise and put out of business when the first payment defaulted or some other defect caused a ‘buyback demand’ which pushed many of the ‘players’ to extinction.

What is happening today?

1. Rising DSCR – Prior to the capital markets shakeup, DSCR was at an average of 1.1:1, which means lenders required $1.10 in NOI for each $1 in debt service. Lenders today are mitigating risk by requiring NOIs are 1.25:1 greater than debt service. NO matter what you have heard even the guaranty programs are doing this. NO matter what you have heard nobody will accept a forecast of income or profit; today it is show me what you’ve had AND what you have right now this minute.
2. Wider Loan Spreads – Previous competition among lenders forced spreads to historically low levels in 2006 and early 2007, with the average falling to 100 to 110 basis points. Everybody suffered because there was not enough money left over to cover the inevitable loses suffered by competing Lenders and Investors.
3. Lower LTVs – Approximately one year ago, LTVs were 75 to 80 percent with SBA publishing 90% promises. The rapid appreciation cycle has ended, and tighter credit markets are demanding lenders to become more cautious and some say paranoid. I other words we all have to think ZERO defaults. As a result, LTVs have decreased to the 65 to 70 percent range and lower.
4. Sliding Values – Values have decreased. Period. The only real judge of this is the appraiser. Period.
5. Less Tolerance- Brokers shopping loans, instead of selling good loans, is causing a further constriction of the availability of capital. Underwriting a loan takes money and no company can afford to spend money to attract shoppers. If you get a loan offer you should present it to your Borrower and solve real issues instead of any perceived drama.

This all might sound mysterious and depressing but it is just another real estate cycle (on crack). There are exceptions, there are mistakes, there are caveats and there are certainly plenty of arguments for and against this synopsis, but one thing for sure is that 2006 is gone!