Current Financial Market Fundamentals are Key to a Successful Real Estate Portfolio

There has been a lot of concern about the financial markets and where this economy is heading. 

Financial and real estate cycles always repeat themselves.  The tricky part is that no one knows when. Trying to time the markets is a combination of a little bit of skill and a lot of luck.  Real estate borrowers that bear in mind the fundamentals of underwriting when lenders have less stringent criteria will also prevail in tougher credit markets as we are experiencing today. 

There are a couple of key criteria to follow when underwriting commercial property and securing debt in any market. One of the first criteria is the Debt Service Coverage Ratio (DSCR).  Providing a coverage of 1.25-1.30x or better typically will put a borrower in a comfortable cash flow position and in return give a level of comfort to the lender.  A second key component to any underwriting and especially critical in today’s market is the Loan to Value or LTV of a particular project or portfolio of properties.  In good times, this percentage can be driven upwards towards 90-95% and in some cases 100%+.  Today the permanent lending market is underwriting at a 60-65% LTV where banks today are typically in the 70-75% range.  The difference between the permanent and bank debt loan to values are non-recourse vs. recourse debt.  The lower loan to value and strict DSCR requirements creates a borrowing environment where cash investors and equity partners will hold a competitive advantage with current market opportunities.  Keeping these two analysis criteria in mind when underwriting a potential deal will always create a successful project in good and bad economic times.

Lender loan spreads are always a hot topic of discussion in the real estate financial world.  Loan spreads will eventually correct themselves, as they are starting to come off the spike from the beginning of 2008.  The shut down or decline of business in the commercial mortgage-backed security (CMBS) market has given banks the ability to generate more business and compete with the permanent markets.  Pricing spreads on loans that used to be 100-150 basis points over the 10-yr treasury are now priced with less concern of a spread but rather with “floor” rates implemented.  These floor rates are ranging between 5.75%-7.00%.

Banks are more frequently competing with the permanent market by offering customers a swap product.  The swap is a fixed rate product typically priced off the LIBOR rate.  This allows the bank to fix the rate for the borrower and depending on where LIBOR rates go in the fixed rate period will determine whether or not it will cost to break the swap prior to maturity or if the bank will cut a check to the borrower. If the swap goes to term then the loan is just paid in full at par. 

There are several other strategies and concepts that could be discussed in addition to the few mentioned above.  The bottom line is keeping the basic fundamentals of underwriting in mind when evaluating a transaction. Be patient and this economic market will certainly prove to be profitable in years to come through future economic cycles.

Written by:  Chris Grobelny, V.P. of Acquisitions for Weston