Cash Is King And Other Lessons Learned In Commercial Real Estate

 

Overleveraging both residential and commercial real estate, combined with crafty packaging of those loans into securities sold to banks and governments around the world, resulted in the sub-prime, or toxic asset, meltdown and contributed to the recession.

Many banks failed – 157 in 2010 versus 140 in 2009 – largely due to losses related to real estate loan portfolios. Real estate values have declined, or underperformed, resulting in losses by borrowers and banks.

Government intervention, as well as deleveraging by business and consumers, has led to improvement today. Firsthand experience with borrowers, as well as media reports, indicate that the economy is rebounding, albeit slowly. Continued action by the Federal Reserve has kept interest rates low, aiding ailing banks that need earnings improvement for their balance sheets and aiding consumers and business by keeping their borrowing costs down during the recovery period.

Although banks are regularly accused of not being willing to make loans, well-capitalized banks with moderate real estate exposure levels are still actively looking at real estate financing opportunities.

Yes, banks have tightened their underwriting guidelines to compensate for previous aggressive practices and to recognize higher levels of uncertainty in our economy. Although the commercial real estate industry and U.S.

economy is slowly recovering, there are some lessons learned by bankers in this recession that influence lending and underwriting decisions. Potential borrowers may benefit from understanding these perspectives.

First, cash and moderate leverage is king. The losses many lenders experienced on projects with higher than modest leverage has re-emphasized the importance of cash in new project financing and on borrower balance sheets. Moderate leverage is a key ingredient for loans.

Bankers expect interest rates to rise, making cash flow growth difficult to predict.

This is no time to over-leverage your property with short-term debt. Most bankers believe your equity and guarantee will likely be at substantial risk at refinance time if interest rates rise. Nationally, approximately $1.1 trillion in real estate debt is maturing between 2011 and 2014.

Secondly, land price volatility is dramatic at the end of a real estate cycle. Real estate land development is inherently risky, and few lenders have an appetite for this level of risk today. For borrowers wanting to finance land, stable cash flow from other sources adequate to support the debt will be an essential requirement for lenders willing to entertain such requests.

Retail, office and industrial property has been negatively affected by the recession and reduced market liquidity as a result of the collapse of the securitization market. In today’s environment, developers need to show that their debt service obligation is covered by capable tenants.

The stage seems to be set for the multifamily housing market to rebound as a result of record low new housing starts, demographics shifting from ownership to rental and tougher home buyer financing terms. This all leads to improving apartment occupancy and rents, yet there are still notable risks in this property class.

The prospect of increasing interest rates, together with questions about the future of Fannie Mae and Freddie Mac as the traditional refinance source, combine to curb lenders’ willingness to make aggressive loans in this property category.

Finally, there’s real value in having a relationship with a portfolio lender, or one that keeps the loan on their own balance sheet, like your local bank. This can prove most beneficial for borrowers who need flexibility, to finance expansion, rehabilitation, or re-leasing of space, or simply want the ability to move quickly when opportunities arise.

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