Finding
today’s best commercial real estate financing is a very different assignment
than it was a decade ago. Savvy commercial real estate investors know that
economic factors, such as jobs and geography, play a bigger role than in
previous years. They also understand that, compared to the market before the
2008 economic downturn, the types of lenders interested in commercial real
estate are very different, as are their underwriting requirements.
To
secure the most advantageous financing, investors need to understand the most
fundamental changes in capital markets. Borrowers are much more likely to find
success when they approach lenders with a thoughtful financing strategy
incorporated in a business plan that both meets expected standards and speaks
lenders’ language.
Investors
who do not have this expertise in-house may want to align with a capital
markets expert who can help them navigate the sea of new underwriting and
regulatory guidelines, diverse lenders, and financial structures that are
available. Such experienced advisers can help borrowers organize information
about the asset into a readable, digestible business plan that capital market
players will quickly understand and respond to.
What
Lenders Like
In
considering loan underwriting trends, one four-letter word incorporates every
lender’s first concern: jobs! The most appealing markets for lending are those
where jobs are being created and are already plentiful, especially high-quality
ones. Areas losing jobs are much less attractive for lenders of all types.
The
“smile” of the United States — a crescent from Seattle through California
across the Southwest, through the Southeast and back up the East Coast — holds
the top choices for all lenders. If underwriters had their way, they’d only be
placing loans in 24-hour gateway cities and primary markets, such as Seattle,
San Francisco, Portland, Ore., Los Angeles, Phoenix, Dallas, Houston, Austin,
Texas, San Antonio, Atlanta, Washington, D.C., area, Boston, and New York.
Underwriting in these blue-chip markets should prove to be a little more
flexible.
Of
course, those same markets are coveted by most developers and investors. As a
result, these markets have become very competitive and offer low yields through
a higher basis, generating more risk. As a result, both borrowers and lenders
are now looking harder into secondary cities and even creeping into tertiary
cities seeking better risk-adjusted returns.
In
second- and third-tier markets, the future of the asset must be stronger than
ever to survive lender scrutiny. These less-competitive markets have
historically produced more-volatile returns, since the loss of even one
employer in a small market can be devastating to the local economy supporting
the asset. Borrowers for these areas should expect to see more stringent
underwriting standards.
The
amount of equity required is another trend that can be challenging. Generally,
long-term, fixed-rate senior financing on most assets will offer approximately
70 percent to 75 percent loan-to-value. For bridge financing, borrowers can
expect to see a greater range of possible LTVs. For instance, interim debt
could range from 50 percent to 65 percent LTV for construction or bridge
financing for repurposing an existing building. Lenders have to be convinced
that assets they underwrite can be credibly projected to be worth more than the
debt at the end of investment term.
Possibly
the most problematic step in today’s commercial real estate loan underwriting
is projecting future interest rates in the current low-rate environment. Both
lenders and borrowers know that interest rates can only go up. The question is,
When and how fast will rates escalate? Borrowers can expect lenders to
scrutinize the capitalization rates used in their projections in an effort to
protect against possible refinance risk. Most lenders will model various
scenarios of interest rates and cap rates and see how much stress is created by
different outcomes.
Commercial
real estate borrowers today also need to match the best type of lender to the
assets they want to finance. For instance, pension funds with long-term
liabilities to their clients are more concerned with financing class A assets
that produce dependable cash flow for 30 years rather than purchase price. On
the other hand, banks are better construction lenders and will offer variable
rate financing, based on Libor with interest rates subject to change each
quarter. For such long-term projects, lenders might also require borrowers to
buy a collar or swap to effectively fix the variable rate of interest and
mitigate future fluctuating rates. Finally, the growing number of private
equity firms, real estate investment trusts, Wall Street funds, and structured
finance lenders offer more choices to borrowers along with varying underwriting
standards.
More
than ever, the flexibility offered by a structured finance strategy can prove
to be an optimal solution for investors seeking to fund projects valued at $15
million or more. Borrowers will most likely need to engage a knowledgeable
adviser to pursue structured finance, but the added expertise should prove its
worth. Such advisers should know which parties to source for different parts of
the capital stack and also be able to create an auction environment, leveraging
lender competition to borrowers’ advantage.
Capital
markets speak a different language and look at deals with a different
perspective. A good intermediary will be able to speak both languages — that of
the borrower and lender — and negotiate favorable deals.
Douglas
M. Thompson, CFA, is the president of VistaPointe Partners, which specializes
in arranging debt and equity capital for commercial real estate. Contact him at
dthompson@vistapointepartners.com.