Brian O'Flanagan, director at Revere Capital

Part 2 of 2

DALLAS—In part one of this exclusive Q&A with Revere Capital's Brian O'Flanagan, we talked about when evaluating a loan request-underwriting if you should evaluate the borrower and the borrower's project separately. In part two, we chat about the art to underwriting and the most common ways of collateralizing a loan among other key topics on the subject.

GlobeSt.com: Is there an art to underwriting real estate loans? Please provide an example if possible.

O'Flanagan: A key consideration of a prospective loan is the sponsor, not only from the perspective of competence but also integrity. While we may have information of past successes and failures and financial capacity, we ultimately need to trust that the sponsor will be able and willing to work through any problems that may come up in executing their business plan before resorting to potentially value destructive defensive measures. In other words, evaluating character is more art than science. That said, I can't state emphatically enough how important hard data and multiple sources of data are for underwriting purposes. And we tend to go find original and raw data ourselves. Broker opinions of value and appraisals are helpful to gain perspectives on proposed projects, yet we can't rely on those assessments exclusively. For example, data can help reconcile major discrepancies, such as an assertion that a property is valued at $200 per-square-foot, but if all we can find is $130 a foot for anything that has sold in that product type and market for the last 10 years, that's a problem.

GlobeSt.com: What are the most common ways of collateralizing a loan, and is anything changing with these practices and standards?

O'Flanagan: Most loans are collateralized by first mortgages and/or other elements, such as pledges of a borrowers' equity in ownership entities, assignment of leases and contracts, and personal guarantees. The latter may vary from full value of the loan to just a significant percentage of the loan. We're holding fast to Revere Capital's standards though I think collateralizing loans would vary from lender to lender.

GlobeSt.com: We have heard that rising interest rates will affect underwriting but it isn't clear why. What do you think?

O'Flanagan: Rising interest rates will likely lead to higher cap rates, which leads to lower asset values. As such, underwriting needs to reflect the higher probability of a decline in value impacting the borrower's business plan.

Related, many market observers expect interest rates to rise 50 basis points this year and it will impact cap rates, which will rise concurrently with rates and even outpace his interest rate projection – cap rates will rise 75 basis points in 2017. Do you agree, and why would cap rates outpace interest rates?

Yes, real estate has greatly benefitted from investor risk aversion and demand for yield that has driven cap rate and spread compression over the past 15 years (with a break in that pattern from roughly 2008-2011 during the recession). If investors reallocate capital from yield oriented to growth-oriented investments, cap rates could increase more than interest rates.

GlobeSt.com: Recently one of our writers did an interesting piece on two regulators associated with CRE lending with opposing points of view and the state of the lending industry, and banks in particular. What is your take on this story?

O'Flanagan: The stories seem quite consistent with what we've been seeing in the market. Bank tightening standards on development and multifamily loans are a direct response to weakening market conditions in those sectors that are oversupplied. However, some institutional lenders are becoming less rigid in their underwriting standards on assets with stronger fundamental conditions, such as office and tertiary markets. Banks are lending, but just are being more thoughtful on where they take risk than in past cycles.

Part 2 of 2

GlobeSt.com: Is there an art to underwriting real estate loans? Please provide an example if possible.

GlobeSt.com: What are the most common ways of collateralizing a loan, and is anything changing with these practices and standards?

GlobeSt.com: We have heard that rising interest rates will affect underwriting but it isn't clear why. What do you think?

Instant Insights /

Exploring the Art of Underwriting Real Estate Loans

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