Getting Back to Basics
IRVINE, CA-The recent fluctuations in the markets have some investors scrambling trying to figure out where they should place their money and what they should do with their current portfolios. Because of this uncertainty, we’re seeing a change in the way investors underwrite and look at real estate. As interest rates rise, real estate fundamentals are beginning to drive underwriting and real estate values.
The importance of being able to get an accurate picture of the current and potential financial health of investments, for both acquisitions and dispositions, is key in the ability to secure financing and maintain the yield requirements of investors.
No longer is it a matter of comparing the current vacancy and rental rates of a property as compared to the market. Investors are also looking at total occupancy costs, knowing that tenants base the amount of rent they can pay on the ratio of occupancy costs/sales. Many times, investors look at items such as common area maintenance, property taxes, and insurance as pass through costs to the tenants, without realizing the impact they may be having on the asking rents and the NOI. However, the capital markets have taken notice and have begun to factor these items into their underwriting.
There are three key factors that most lenders look at when underwriting properties: debt yield, loan to value and debt service coverage ratio, using the lowest of these three ratios to determine the amount of financing that can be placed on a property. Often times, it is debt yield, which is the NOI (as determined by the lender), over the amount of the loan, which is a ratio many investors aren’t as familiar with. The current condition of the property, including capital needs and vacancy, factors significantly into a lender’s underwriting, having a direct impact on the NOI calculated by the lender, and ultimately the proceeds available from debt.
Even with market fluctuations, one thing has remained constant: investor yield requirements. Most investors are looking long-term and the days of being able to rely on cap rate compression to create value are few and far between. This has caused investors to focus more on their ability to create value through effective and efficient management and operation of the property. To do this, they need to have a clear picture of its current financial health and be able to see where the opportunities lie to increase the NOI through cost savings. Any savings realized through a reduction in operating costs can be transferred to increased rent without increasing a tenant’s overall cost of occupancy, which has a direct positive impact on the NOI.
Investors today are looking at minimum 5% cash-on-cash returns at the time of purchase, but need to be shown how to increase this to 7% or 8% over the hold period. This is where the importance of accurate and factual underwriting has its biggest impact, regardless if debt is to be placed on the property. In the past 18 months much of what was driving the investment market was finance and yields. As interest rates go up, real estate fundamentals matter making management performance and real estate operations the key drivers. Having complete information and understanding is significant. Expect pressure in cap rates and pricing if not underwritten correctly and factually. Otherwise the re-trade conversation will pop up more and more in negotiations. Even if an investor doesn’t put debt on a property, they will still look at the marketplace in terms of yield and adjust their price and expectations accordingly. Being sensitive to changes in financing becomes critical during the entire transaction process.
As we move into 2015 through 2017, it’s important to look at the effects of the maturing CMBS market and the impact of those maturing loans on the marketplace. It is expected that a substantial part of the maturing loans will not be able to be refinanced. Putting property back on the market inside a changing finance market, especially as interest rates go up, could put continued upward pressure on underwriting and pricing.
There is a benefit to increasing interest rates, which in most cases is due to the increase in the Treasury rates. Many investors that placed CMBS debt on their properties in the mid-2000s did so at rates higher than the current market rates, and the fact that the Treasury rates have been so low over the last several years has prevented them from either selling their properties or refinancing due to the high cost of defeasing the in-place loans. While it is possible to sell a property today with in-place CMBS, as it can be assumed by the next buyer, the high rates of the in-place debt cause the properties to trade at higher than market cap rates, in order to maintain investor cash-on-cash requirement.
With an increase in the Treasury rates, the cost of this defeasance has dropped, so now is a good time to revisit those investments with higher in-place interest rates, especially if the property would demand a lower cap rate if offered as “free and clear” to the market. There are a large number of investors who pay all-cash, which would increase the buyer pool for an investment. In these times of demand outpacing supply, the ability to increase the size of the buyer pool for a property, can have a significant impact on the value of the asset.
Chad W. Owens, is VP of operations at Faris Lee Investments. The views expressed in this column are the author’s own.