Understanding Today's Underwriting Criteria Makes Refinancing Easier
With historically low interest rates still available, many property owners are seeking to refinance their loans. However, they should be aware that today's lenders underwrite real estate values far differently than in the past by using a relatively new set of cash flow adjustments to determine loan amounts. The new underwriting criteria increase the probability of a discrepancy between a borrower's perception and a lender's actual valuation of a property and significantly impact the amount of loan money available.
Adjustments Affecting Cash Flows
To determine if an anticipated loan amount is realistic, borrowers should understand how lenders use the following cash flow adjustments.
Rent. Landlords that consistently achieve above-market rents expect to be compensated with stronger cash flows and enhanced property values. However, lenders often consider such high rents to be “at risk” and write rents down to reflect market averages when formulating their underwritten cash flows. This strategy safeguards lenders if they need to take over the property and release the space.
Management Fees. Many owners who manage their properties charge back few management costs to the property. However, lenders view management fees as a standardized number, reasoning that they would need to engage a third-party company to manage the asset if they took over operations in a default. As a result, most lenders impose a 4 percent to 5 percent management fee against income, regardless of the borrower's actual charge-back fees.
Vacancy Allowance. Owners often expect to underwrite actual vacancy in their property, while most lenders underwrite the greater of actual or market vacancy. Lenders make this adjustment to account for inherent real estate risks, such as when leases roll, tenants default, and ownership changes hands. If the lender were to take ownership of the property, it would assume a vacancy allowance that is reasonable in the market.
Operating Expenses. Lenders often underwrite a property's trailing 12-month expenses, which negatively affects net income since recent expense increases, such as insurance and taxes, are included. Lenders also rely on the market to set minimum underwritten property expenses, which penalizes owners that operate their properties more efficiently.
Reserves. Structural, tenant improvement, and leasing commission reserves are areas where lenders further decrease underwritten cash flow. Lenders collect and underwrite reserves for numerous reasons, one of which is to “smooth out” operating numbers. Smoothing compensates for large irregular expenses that owners incur when re-leasing space and making capital investments in their properties. Smoothing also provides a more-friendly analysis to bond buyers who rely on a regular, durable cash flow stream. Secondly, reserves provide the cash lenders need to have on hand to cover these irregular expenses.
Refinancing or Sizing Constraints. Lenders determine maximum loan amounts utilizing a stressed loan constant in which they estimate debt service at loan constants typically in excess of 10 percent. Loans then are sized to cover this stressed debt service by anywhere from 1x to 1.05x the cash flow, which can result in loan dollar decreases in low interest rate environments.
This example illustrates how a borrower's idea of value can differ greatly from the lender's calculations.
Dan owns a 10,000-square-foot office building and wants to refinance. The property is 90 percent net leased to a variety of good tenants, some of which signed long-term leases at above-market rents. Historically he has managed and leased the property internally, thus boosting cash flows by saving on third-party management expenses and lease commissions.
The property generates rents of $100,000 per year, and Dan also receives approximately $1,000 in other income from miscellaneous sources. The building shows operating expenses of $19,000 per year. For budgeting purposes, Dan expects his building to be fully leased through much of the year and budgets to recoup the entire $19,000 in operating expenses. Therefore, he calculates an effective gross income of approximately $120,000 per year.
After a nominal 2 percent management fee adjustment, Dan anticipates a net cash flow before debt service of approximately $99,000 per year. Based on a market capitalization rate of 9.25 percent, he believes his asset is worth approximately $1.1 million, an opinion he has confirmed with the brokerage community. Given his track record, Dan thinks that 75 percent financing should be readily available, and he expects to obtain financing in excess of $800,000.
However, in underwriting the loan, the lender writes the above-market rents to market, resulting in an adjustment of $1 per square foot on 3,000 square feet, or $3,000 per year. Additionally, as lenders generally do not underwrite non-sustainable or non-operating income, the lender negates the additional income with a negative adjustment of $1,000. In this case, the actual vacancy is the same as market; however, the lender takes a vacancy adjustment on expense reimbursements, resulting in an additional negative adjustment of $2,900. On the expense side, the lender underwrites a 4 percent property management fee, an adjustment of $2,400 over the $2,000 that Dan had charged. The lender also adjusts cash flow by 20 cents psf for structural reserves, 50 cents psf for tenant improvement reserves, and 50 cents psf for leasing commission reserves, which adds up to a $12,000 downward adjustment. In all, the lender's underwritten cash flow differs from Dan's by $21,300.
Most lenders utilize loan-to-value and debt coverage tests to determine maximum loan proceeds. In the LTV test, the lender applies the same 9.25 percent cap rate to his net operating income number. The result is a valuation of $948,000. A 75 percent LTV constraint produces a maximum loan amount of $711,000. For the debt coverage test, the lender utilizes his adjusted net cash flow amount of $77,700 as opposed to Dan's calculation of $99,000. He applies a 1.40x debt service coverage constraint resulting in $55,500 available to pay debt service. Assuming a 6 percent interest rate with a 25-year amortization, $55,500 per year relates to a maximum loan amount of approximately $718,000.
Most capital markets lenders also apply a stressed test or rating agency test. Big rating agencies such as Standard & Poor's and Moody's provide lenders with a matrix of these stressed constants. In this case, the lender utilizes a 10.53 percent stressed constant after which the debt service must be covered by 1.05x. This calculation results in maximum loan proceeds of only $702,800.
Lenders typically limit their loan proceeds to the minimum result of the three tests. Here, the maximum loan is only $702,800.
As this example shows, borrowers should stay abreast of changes in the way lenders adjust cash flows.