Underwriting with confidence at time of uncertainty.
Commercial underwriting challenges
Much has been written about the Covid19 pandemic, and its effect on commercial real estate. Physical distancing, stay-at-home protocols, and mandated business closures, have had an as yet indeterminate effect on commercial lenders, their existing portfolios, and their go-forward lending strategies. Many commercial real estate assets will be forever altered. Real Estate buyer sentiment and space user demand has and will continue to shift. Asset values are seemingly fluid until market participants’ return, and new price points are created.
In this uncertain environment, commercial mortgage underwriting is ever more challenging. Frankly many lenders may simply be reluctant to resume activity until a clearer picture emerges. A significant economic turnaround may be some time off, and to be sure, “normal” activity will not resume with the flip of a switch. Business continuity requires that a go-forward lending strategy be adopted.
Recommended underwriting changes
Here are some of the commercial credit underwriting changes we would recommend and will expect to see from commercial mortgage lenders in the near term:
–Lower loan-to-value ratios. Simply put, if there is a commonly held belief that commercial real estate values have been negatively impacted, and certainly some assets much more so than others, then we would recommend lenders exercise caution, and dial back their loan to value ratios. Once buyers and sellers return to the market, landlords and tenants work through and stabilize rental rates, and vacancies are identified and factored into current real estate appraisal activity, then more normalized lending activity can resume.
–Asset specific pricing. Risk premiums need to be re-introduced for certain asset classes. Pricing should reflect quality. Triple “A” tenanted properties most certainly warrant keen pricing. Lesser quality “B” class assets warrant a risk premium. Ditto for renewal considerations. Identify the “at-risk” portion of your loan, and price it accordingly.
-Focus on Cash Flow. Pay close attention to property cash flow when underwriting credit. Contractual rents are realizable from creditworthy tenants. Actual rents collected, from lower quality tenants, may be quite a different story.
-Focus on Borrower Covenant. As we collectively work towards a re-establishment of economic activity, it is clear that there will be winners and losers. Since commercial tenants’ businesses may be strained, and their ability to honour rental agreements may be in some doubt, now is the time to place greater reliance on the financial wherewithal of the borrower/guarantor. Borrower track record should be a key metric.
-Use all available tools. Though oversimplifying, there are 4 key variables available to any lender. Loan amount, loan term, amortization, and rate. Use them strategically as you ease back into lending, and loan renewals. Make that loan and renew that credit, but consider dialing back the loan amount, shortening the amortization period, and adopt risk based pricing, should the situation warrant.
A more stable economic landscape will soon emerge. Let ACRE Advisory Commercial Real Estate assist. You can underwrite commercial mortgage loans in a time of uncertainty!
Good review Allan. One area I’d like to see commercial real estate Lenders better explain is the Federal Government response to Covid-19 for developers. The BDC loan program clearly does not pertain and yet Developers have goods and services they provide and lower loan thresholds are requiring them to come up with more equity they often do not have, especially in this environment. It is often the difference in a project going ahead or not, in some cases potentially employing hundreds of workers at a time when unemployment in the construction trades is under severe stress.