New order of sense for commercial real estate lending.

If one were to compare real estate financing to hands on a clock, with 12 p.m. representing the robust real estate lending climate of the mid 80s and 6 p.m. connoting the depression of the late 80s and early 90s, then 8 o'clock would signal today's healthy lending period. This current economic cycle is marked by, to borrow a phrase from Jane Austen, a new order of "sense and sensibility."

Real estate financing has picked up because the real estate industry is improving, with some sectors like multi-family housing and certain Class-A and Class-B office buildings recovering more quickly than others. This overall good news has created a viable lending climate for the first time in several years. In the late eighties real estate prices were grossly inflated. When the downturn came, the impact on real estate was severe. Owners of highly leveraged properties could not support their underlying mortgage obligations which triggered a massive number of defaults.

Like all business cycles where a depression is often followed by a rebound, we appear to be climbing out of the trough. However, in this recovery period we have entered a new era of sense and sensibility in commercial real estate underwriting as evidenced by the steps lenders have taken to guard against future problems.

Let's take a look at how these new bank lending practices apply to office, multifamily and retail properties.

Changes in office building underwriting criteria

We need only look at Class-B office space in midtown Manhattan to grasp the changes.

In the mid-80s rents were around $24-$25 per square foot. By the late 80s and early 90s prices per square foot had dropped to $17, a threshold at which the financial statements of highly leveraged properties showed negative cash flows. A correction followed between 1990 and 1992, resulting in foreclosures and bankruptcies.

The good news today is office space leasing rates have risen to $22-$24 per square foot in midtown Manhattan Class-B space, a level that can generate a positive cash flow. The other important news is lenders and owners alike have adopted new models for financial projections and underwriting that apply a healthy conservatism to the process.

In the 80s lenders tended to project only the upside of rent rolls and their financial models, while expenses were typically estimated at a moderate rate of increase. The critical problem was these cash-flow analyses were never stress-tested. It commonly was assumed that a building's first-year cash flow would be repeated over the lifetime of the property.

Today our underwriting techniques are more sophisticated as well as conservative. Cashflow analyses now take into consideration important building criteria, such as the amount of time it takes to relet vacant space, the cost of marketing space and undertaking tenant renovation programs, and the need for capital improvements (i.e. boilers, windows and elevators). Typically these new assumptions are used in a cash-flow model that reflects peaks and valleys in a building's economy over a ten-year period.

Changes in multi-family underwriting criteria

While multi-family underwriting in the early eighties focused primarily on vacancy factors, collections were frequently ignored. Recent experience has shown a building may be 100 percent rented but only 80 percent collected. Today lenders focus on the collection cycle (i.e. aging and delinquencies) as well as a vacancy factor.

In addition, the cost of capital improvements is critical to the future value of a multi-family property. Key elements such as new boilers and facade repairs are now factored into loan decisions.

Another area of concern to lenders today is the cost of maintaining the building, which typically runs 10 percent of the gross income on an annual basis. This element is especially important in a highly trafficked, multifamily building where maintenance costs can often run higher than 10 percent of the gross income.

Changes in retail center underwriting criteria

As a result of significant upheavals in the retail industry, underwriting criteria for strip shopping centers and suburban malls also have undergone changes.

For one thing, lenders today spend more time studying the financial conditions of key anchor tenants. This development in underwriting practices is particularly important in regard to a retail center that has a big-box footprint, since a large space is often difficult to reconfigure should the anchor tenant vacate. Lenders have learned to become cognizant of alternative uses for a big-box space in preparation for the possibility of having to replace a major tenant.

Other retail fundamentals lenders should be aware of are related to traffic. These factors include the need for adequate access and egress to and from major traffic arteries.

Other changes in commercial real estate underwriting criteria

Commercial mortgage underwriting has been The East New York Savings Bank's principal business for over a century. The bank originated the same level of loan product in 1991 and 1992 that we are currently writing. The difference is that today, in addition to our own balance sheet, we are utilizing the programs of Freddie Mac and Fannie Mae as well as real estate conduits. These programs create a healthier lending environment because they provide additional sources of liquidity.

ATWOOD COLLINS, III President and CEO The East New York Savings Bank