Traditional Lenders in Modern Times
A Guide for Borrowers
Over the last five years, providers and users of capital in the commercial real estate industry have lived through an uncertain and pessimistic time unprecedented in recent memory. Beginning with the savings and loan crisis in 1988 and 1989, a series of shocks struck capital providers. The failure of the Bank of New England and huge losses on mortgage portfolios raised the specter of a commercial bank crisis similar to the savings and loans debacle. The collapse of Mutual Benefit and First Executive, with the former blamed primarily on soured real estate investments, raised questions about the financial stability of the U.S. insurance industry. Other startling events included the retreat of foreign debt and equity investors, and continuing concern over the health of real estate portfolios held by pension funds.
While real estate represents only one segment of the investment portfolios mentioned above, the losses suffered in this segment received extensive treatment in the popular and trade media and was scrutinized by regulators and rating agencies. As the spotlight focused on commercial real estate, only the "warts" of the industry were revealed-the overbuilding, the bankruptcies, the foreclosures, and the massive losses.
In this environment, institutional decision makers determined that real estate carried far too much baggage, making it an unattractive investment. Allocations of new investment dollars for real estate were slashed. In some cases, institutions were forced to liquidate their real estate assets to meet the new investment portfolio guidelines of regulatory and rating agency. The end result was the "credit crunch" of 1991 and 1992, when both perception and reality said that traditional capital was unavailable for real estate investments.
During the last quarter of 1993, evidence suggested that the capital crunch had eased, if not ended. A survey of institutional lenders conducted by Cohen Financial in mid-1993 revealed that nearly three-quarters of all lenders planned to increase or maintain their existing allocations. Of those planning to increase allocations, 75% contemplated increasing the allocation to real estate by more than 10%.
Renewed Commitment to Mortgage Investments
Traditional real estate capital sources-primarily life insurance companies and commercial banks-recently renewed their commitment to mortgage investments for a number of reasons. First, a growing consensus of lenders believes that mortgages placed in today's market reflect real values and underwriting criteria. This consensus provides a foundation of confidence in mortgage investments. Second, the current mortgage market offers yields that far exceed those available in alternative investments such as government and corporate bonds. Third, many mid-size institutions, and especially mid-size insurance companies, find that overall asset growth has lowered the percentage of mortgage investments in their portfolio. These institutions have room to grow their mortgage portfolios without incurring the wrath of regulators and rating agencies.
The reality that traditional sources of real estate capital are actively making loans conflicts with the current belief of the borrowing community. This became evident when Cohen Financial surveyed 600 borrowers. According to the study, 85% of the borrowers believe that traditional sources of mortgage capital now seek to reduce or eliminate new mortgage origination. The disparate results of the two surveys suggests a wide communication gap between capital providers and capital users. In order to bridge this gap, a capital user must understand the framework that defines how traditional lenders make a loan in today's real estate environment.
Bridging the Communication Gap
First, it's important to acknowledge that certain property types are more attractive than others. Some product types, almost regardless of the economics of a particular transaction, will fail to attract capital from tra ditional lending sources. Alternatively, other types of property will attract myriad investors.
Second, the borrower needs to recognize the underwriting parameters of today's lenders: a loan proposal that fits these parameters will receive attention; a proposal that pushes the edges of these parameters will be considered; a loan proposal that completely ignores underwriting criteria will likely languish in a paper pile on someone's desk, waiting for a rejection letter.
Third, the borrower must package a proposal in an understandable and efficient manner. During a proposal, the borrower should present information in a way that allows a lender to make a reasonable and informed decision about whether to go further on a project.
Finally, the party that presents a loan proposal should have some credibility with the capital source. Because an enormous number of existing and proposed properties require financing, credibility with the lender can be a key element in raising the profile of a typical transaction.
Desired Product Types
Today's transactions fall into two broad categories: credit transactions and real estate transactions. In both cases, lenders focus on quality. In credit transactions, quality refers to the dependability of the income stream that a lease will generate. The lender assesses this dependability by the creditworthiness of the lessee. Today, "credit" refers to a lessee that has received an investment-grade rating from one or more of the major rating agencies. For Standard and Poor's, the lowest investment grade is BBB, while the equivalent Moody's rating is Baa. Other rating services include Duff and Phelps (lowest investment grade of BBB-) and the National Association of Insurance Commissioners (NAIC) (lowest investment grade of 2). Yet, for a private company that carries no credit rating, this reliance on ratings becomes a problem. In such cases, the borrower may ask the credit analysts in the lender's bond department to render an internal rating to establish a credit designation. The analysts can scrutinize the financial condition of the tenant as would the previously mentioned rating agencies. They examine balance sheet ratios, sales and profit-ability trends, and overall business conditions for each tenant. Based on their examination and analysis, the analysts will then assign an internal credit rating to the tenant.
Once lenders have established that credit underlies a transaction, they will consider providing financing for just about all property types.
The most prevalent credit transactions to-day are free-standing retail buildings, such as Kmarts, Wal-Marts, and Walgreen's Drug Stores. Build-to-suit industrial and office properties follow in terms of number of transactions and lender consideration. Unfortunately, multi-tenant properties, which represent the bulk of existing real estate assets, do not lend themselves to this type of credit analysis. In the parlance of the lending community, these properties represent "real estate transactions."
Real estate transactions are those that exhibit some form of leasing risk, market risk, or risk of competition-in short, all of those risks normally associated with real estate projects. While some level of these risks will be present in any real estate transaction, lenders focus on those property types that appear to minimize the risks. The lending community has a strong appetite for these property types:
- garden-style apartment complexes
- dominant regional malls
- grocery/drug store-anchored retail centers
- warehouse/distribution facilities
The particulars of a certain project and a certain market will, of course, be the initial focus of a lender, regardless of property type. Garden-style apartment complexes, for example, enjoy high occupancies, rent increases, and a low level of new competition in most parts of the country. This property type is high on nearly every lender's wish list. Be-yond project and market particulars, though, the property types listed above share a common factor. Each of these property types tends to fulfill a basic need.
Obviously, apartments provide for the basic housing needs of their residents. Grocery/drugstore-anchored retail centers offer products that attract consumers on a consistent, everyday basis. Dominant regional malls offer a wide enough array of goods and draw from a sufficient trade area to generate the same type of consistent traffic. Warehouse/distribution facilities provide a basic input to business, somewhat analogous to what apartment complexes provide to renters. Given the growing importance of the distribution function in the overall economic framework of the United States, the need for these properties will continue to grow.
By supplying basic needs, each product enjoys a certain level of constant demand that minimizes the risk of negative variance in the cash flow of the property. Minimizing this risk reduces a lender's greatest worry-loan default.
An understanding of current underwriting criteria is as important as recognizing the property preferences of institutional lenders. For real estate transactions, lenders emphasize a stringent underwriting of cash flow to arrive at a meaningful net operating income figure.
On the income side, this means a market vacancy/credit loss factor against all income (with the exception of that from long-term, credit leases). Rent rolls are scrutinized for higher-than-market rates; and rental income may be discounted if rates are high.
The expense side includes a reasonable management fee and a structural/ replacement reserve line item that bears some relationship to actual costs of replacements. If appropriate, cash flow projections also include expenses for leasing commissions and tenant improvements.
This net operating income figure will be used to establish the value of the property. When sizing a loan amount, today's lenders attach significance to the loan-to-value ratio. A loan equal to 75% of value once represented the norm, but now many lenders consider this a "full" loan. Many have established a 70% loan-to-value ratio as an upper limit; some cap their exposure at an even lower level. The debt-coverage ratio is still important, with most lenders requiring a minimum 1.25:1 ratio. However, the dramatic decline in interest rates over the last 24 months has lessened the practical significance of this ratio, as illustrated in Table 1.
Given the loan terms outlined in Table 1, a lender could value a property using a capitalization rate as low as 8.67% and still achieve a 1.25:1 debt-coverage ratio. With the exception of premier garden-style apartment complexes and regional malls, this cap rate falls well below that commanded by most properties. As illustrated in Figure 1, a loan of 75% of value, with a 10% capitalization rate, enjoys a hefty 1.44:1 debt-service-coverage ratio.
Packaging a Loan Proposal
The packaging of the investment opportunity has increased in importance. A submission consisting of a one-paragraph description of the property and a "stabilized" pro forma no longer generates a response from a lender. An initial package should have enough information for a loan officer to make a reasonable assessment of the project. At a minimum, this information includes a detailed rent roll, summaries of major leases, photographs, location maps, and historical operating statements, a pro forma, and a detailed property description. The information should be presented in logical order and in a professional manner. If the transaction progresses beyond the initial stages, you must present detailed cash flow projections based on defensible assumptions and relevant market and comparable-property information. The initial package and every step in the process requires significant time and effort. Many owners and developers may not have the available time or the experience to collect the copious information and put it in the necessary form. But doing so is critical to a successful presentation.
In the same way that the name of a major investment banker lends credibility to a new security issue, the party that presents the transaction to a lender will influence the perception of the project. A particular property owner may have established credibility with one or several lenders through past business dealings. Such credibility will make a transaction stand out from others vying for attention. However, if one must go beyond this small group of lenders, a typical transaction competes on equal footing with all others on the desk of a loan officer.
If you lack established business contacts, you can establish personal relationships through social interaction or participation in industry organizations and associations. These relationships can be effective in establishing the credibility needed to complete a transaction.
A property owner can also enlist the aid of a financial intermediary. Intermediaries can assist in establishing credibility for a transaction with those lenders whom they represent, and in the larger lending community. The intermediary usually knows what property types are preferred by particular lenders and understands the nuances of their underwriting parameters. Intermediaries generally are familiar with the appropriate packaging and presentation of the loan proposal.
Money Is Available
Financial institutions have displayed a diminished appetite for new real estate investment over the last several years, at least in comparison to the pace of investment in the mid and late 1980s. Nonetheless, real estate continues to constitute a sizable segment of the investment portfolios of such institutions. Performance of this segment has stabilized, and it seems that real estate lenders have weathered the worst of the industry's problems. Signs indicate that traditional real estate lenders are increasing their activity in mortgage originations.
Caution and conservatism will temper and direct this new activity. The successful borrower must know the underwriting guidelines and product preferences that will control lending decisions. That borrower must also commit the time and effort to providing the high level of detail and disclosure required of an acceptable loan submission. Finally, the party that presents a transaction for consideration must have credibility with the lending source. A borrower that acknowledges and accommodates these considerations will find that money is available from traditional lenders.