Back to basics: changing face of CRE financing.
To give you a better understanding of how the market works, allow me to digress and explain the securitization of loans originated on Wall Street. After Wall Street lenders finance loans, they group these loans into a pool. The loans are then prepared to be sold off to various investors in the "market". Rating agencies such as Moody's and Fitch rate the pools, and assign various levels of risk to each tranche, or portion of the pool. The ratings are grouped as follows: AAA--This is about 80% of the pool, considered to be the least risky, and is sold at lower rates. The remaining 20% are split up further, and grouped as AA, B, B-, and "unrated". These tranches of the securitized pool generate the highest return, commensurate with the greater level of risk to the purchasers of the securities. The total blend of the whole pool works out to include a profit to the Lender.
Of late, these CMBS Loans (Commercial Mortgage Backed Securities) that Wall Street had been financing lowered their underwriting standards to the point where negotiating on a loan came down to one of three tactics:
(1) Competition- Lenders were very lax in their underwriting. If you had a proposed a loan structure to a lender, and had it turned down, all that was needed to change their mind was to show them a competitor who was willing to do the deal, and they would compete almost instantly.
(2) "But the Cash Flow is there!" When a lender would come back to a borrower with concerns of short term rollover, high tenant improvement costs, etc, the answer to all concerns was "just look at the cash flow!" This solve-all answer did not require the broker/client to use a mathematically based logic solution; all they had to do to get the lender to get to the requested loan amount by suggesting a reserve structure that sounded large enough using cash flow based on Interest Only or future (potential) cash flOW.
(3) "But you promised me!" I remember walking into various lenders who would quickly glance at a deal and give an aggressive quote. When it came to delivering an actual term sheet, or issues would arise threatening the original quote given, all that was needed was a "but you promised me!" and lenders would figure out a way to keep their original terms.
In mid April 2007, CMBS buyers finally said "Enough!"
The investors purchasing the CMBS pools exercised their right to throw deals out of the pool (an occurrence which had been extremely rare). They were not going to buy notes--even AAA notes--the lax underwriting standards made the risks too great.
Additionally, investors began demanding a higher return on the tranches of the pools they were buying.
The number of deals thrown out of the pool jumped to levels unheard of in recent years. This instantly created a grave concern for the Wall Street lenders. If they could not sell off their loans, they would have to keep them on their books, thereby not allowing the funds to be re-circulated.
I believe we are now in a time where the economics of real estate have changed. No longer will lenders give borrowers whatever is requested. We are moving from a borrower's market to a lender's market. I believe lenders will now base quotes and loans on the quality and location of the asset, as well as the strength of tenancy.
Schecky Schechner, Head of CMBS Loans for JP Morgan addressed some of the major ramifications this will cause:
Lenders will no longer finance acquisitions that are 85% Loan-to-cost (LTC)/80% Loan-to-value (LTV); Lenders will not underwrite loans exclusively based on future (potential) cash flow; Lenders will not underwrite DSCR (Debt Service Coverage Ratios) based on "Interest Only" loans.
"Furthermore," he continues, "Lenders will no longer securitize unstable deals; they will be priced on a floating rate basis, or given to a portfolio lender."
In addition Schechner sees room in the market for spreads to widen another 10bps.
What does this all mean for the commercial real estate market?
Firstly, buyers looking to purchase a property will have to start putting more equity into deals, since the leverage they grew accustomed to through aggressive financing is no longer available.
Shaya Sonnenschein, senior analyst at Eastern Union lays out a likely scenario: "Investors were accustomed to getting a $20,000,000 purchase (at an 8% cap rate) financed with their closing costs at 85% Loan-to-Cost, so long as it appraised for an 80% Loan-to-Value, with the full term Interest Only.
"This would yield a loan amount of $17,510,000 (using a 3% closing cost assumption), and a 16% cash-on-cash return. In this new environment, the same cap rate and an 80% LTV/LTC loan with no Interest Only, will yield a cash-on-cash return of 9.75%. In order to achieve the original return (16%), the price of this property would have to decrease to about $17,000,000."
Flippers, Lenders, Buyers, Investors, and Mortgage Brokers may all feel the affects of this new market. Since Flippers were able to sell properties at higher prices based on potential cash flow projections, in this market they will have much less room to increase prices. The wide financing parameters they grew accustomed too, which in part allowed for a better cash flow projection is no longer as available. In some cases Flippers may be squeezed out of the market entirely.
Lenders that were focusing on straightforward fixed-rate products are seeing a dip in their production as they tighten underwriting standards. Lenders that focused on more structured and bridge financing are seeing an increase in production.
Buyers and Investors will initially see a decrease in opportunities for buying; however they should see a correction where prices either stabilize, or are reduced.
Mortgage Brokers who were accustomed to making a phone call without a solid understanding of the deal will not be able to continue business as usual.
The reasons for this are as follows: 1. Lenders who previously may have allowed unanswered questions to slip by, are now going to ask for real answers before they lend.
2. Buyers of Real Estate will need a broker who understands their deals and will bring it to the lender that has the best shot at closing the deal.
3. Lenders will need an experienced mortgage broker to communicate with on deals, as even "regular" financing will now need more structure.
Overall, the more sophisticated broker should see an increase in business, as buyers will need more than their one personal banking relationship to get the best deals in the market.
"Our decision to educate our brokers to understand and finance all of the different property types, in addition to our continuously growing list of local and national relationships with various lenders, proved to be the right move", says Abe Bergman, executive VP at Eastern Union.
"The standard straight multi-family deals have become increasingly limited. This growing need for financing of diverse property types has now positioned us to be the dominant brokerage company in the market.
In closing, we do not know what the market will bring.
The Commercial Real Estate market is still at record levels, and rents in many markets continue to rise. Furthering this notion, the amount of new transactions we are originating has increased.
I believe the savvy buyer, investor, lender and broker have made or will make the adjustments necessary to face the new reality of today's market to succeed.
BY IRA ZLOTOWITZ, PRESIDENT,
EASTERN UNION COMMERCIAL
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|Comment:||Back to basics: changing face of CRE financing.|
|Publication:||Real Estate Weekly|
|Date:||Jun 13, 2007|
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