Underwriting Adjusts As Pandemic Continues

Last August a multifamily property went on the market in Los Angeles with cash-flow issues that would have made an underwriter pause even without a pandemic underway.

There were five vacancies and seven additional tenants weren’t paying rent due to the pandemic. Income in the property was completely off, according to Mik Hanassab, a senior director at James Capital Advisors, who was marketing the building. The building sold in an off-market trade to a buyer that was not concerned about the loss of income and who was able to secure a 70% loan-to-value. If it had gone to market, it could have traded for about $500,000 more, Hanassab speculated.

In this case it is unclear exactly what made the underwriter sign off on the deal, but Hanassab’s business partner, Elliott Hassan, has his ideas.

“Every property is a case-by-case situation, based on location as well as operations and rent collections. Properties with bad operations are not going to be able to get top dollar, but well-managed properties are still going to go out there and do well based on collections,” Hassan said.

Here’s a secret to CRE underwriting in the COVID era: once the initial shock of the pandemic wore off, underwriters haven’t been as conservative as many had feared. Of course some asset classes almost write themselves: for instance, in some markets multifamily has returned to pre-pandemic pricing making the underwriting a routine matter. Other asset classes, such as hotels and retail, are experiencing more profound shifts for obvious reasons.

None of this is to say that underwriting hasn’t become more conservative. It undoubtedly has. But underwriters haven’t seized up in paralysis and, in fact, many are putting in place workarounds to make deals pencil in.

For example, some lenders are now doing what’s called a “COVID Reserve” where they hold some capital back for six months to one year or until the pandemic is over and have the confidence that tenants are paying their rent again. Then they release the funds back to the borrower.

That said, underwriting clearly has been affected by the pandemic-led downturn. In short, lenders are using higher vacancies and reserves to underwrite, leading to more conservative loan proceeds.

For instance, loan to values are down 5% across the board, an example being if somebody was matching out at 70% loan to value before the pandemic lenders are likely to max out at 65% now. If there was a debt-service coverage ratio of a minimum of 120% now, lenders are likely at 125%. Cash-out on properties has been conservative as well with lenders wanting to see as much equity in the property as possible.

Even in the multifamily space, where government-sponsored enterprises have been active, assumptions surrounding operating expenses, vacancies, market concession rates and supply trends are being closely examined by lenders. Concessions, for example, have increased significantly since the pandemic and underwriting is now taking that into account, according to Daniel Withers, senior vice president and senior director at Matthews Real Estate Investment Services. The market is seeing operators offer one to three months of free rent and waive an array of fees that they would have previously charged, such as pet deposits, parking fees, and key/removal charges, he says.

Increased concessions will put downward pressure on revenue and net operating income. To secure a debt on a deal, investors will need to increase capital reserves to compensate for this decrease in revenue. “When going out to the capital market, operators should anticipate increasing reserves in both purchasing and refinancing,” says Withers. “Lenders now require six-18 months with debt service reserves to proceed. We suspect that the higher-than-normal increase in debt service reserves will remain for the entire 2021 and perhaps even into 2022.”

Lenders are also scrutinizing borrowers’ credit profiles more closely than before and in many cases are declining to work with companies that have received strategic forbearance.

GETTING DEALS DONE

However, once you navigate past these limits, deals are getting done.

For instance, according to a Marcus & Millichap report, apartment and industrial properties have been able to draw greater interest with banks and non-agency lenders remaining active originators, most often funding five- to seven-year loans with rates in the upper-2 to mid-3% range. Evolving e-commerce trends, challenges in the single-family home market and limited capital expenditure requirements have helped to ensure financing remains available at favorable terms for both asset classes, Marcus & Millichap said.

For the office class, though, most lenders have been more selective when assessing properties in spite of strong rent collections, favoring suburban office deals while requiring loan-to-values closer to 50% for buildings in larger downtown markets. Life insurance companies have been targeting lower leverage deals in the sector as well as focusing on multifamily and single-tenant retail assets, according to the Marcus & Millichap report.

In some cases, lenders are willing to stretch their comfort level to make a loan, depending on the asset class. Life sciences, clearly, has become a popular asset class but not many lenders understand the nuances associated with it. James Millon, vice chairman, debt and structured finance at CBRE, points to the recent life science conversion of a traditional office building at 345 Park Avenue South in New York City that his firm conducted. At first lenders did not understand the infrastructure required to attract the lab tenants and that a life science project could exist outside of a traditional hub, like Cambridge, he says.

On the other hand, asset classes with reputational risks can be difficult to underwrite even if the hard numbers pencil in. Lending to a senior housing facility that has had COVID deaths could potentially provide a reputational risk for lenders. “Frankly, it’s just better to wait things out, let the storm blow over and start financing these asset classes again,” Millon says.

Even retail, which suffered a wallop from the pandemic, is finding that deals can be underwritten. “There is a myth that retail is unfinanceable today and that’s absolutely untrue,” says Christopher Drew, senior managing director, capital markets at JLL Americas. “When structured appropriately, plenty of financing is available to investors. In fact, certain lenders like local and regional banks never stopped lending. Lenders seek the same characteristics for retail that investors pursue, which is well-located assets with essential tenancy.”

JLL capital markets retail debt placement teams closed $542.83 million worth of retail financings between July 1, 2020 and November 30, 2020. Of the 29 JLL retail transactions closed during that time period, 12 were grocery-anchored retail assets. The remaining loans were a mix of non-grocery-anchored, shadow-anchored retail, retail condominiums and single-tenant assets. The average loan-to-value was 62% with an average interest rate of 3.96%. Grocery-anchored deals had an average LTV of 63% and average rate of 3.79%, with an average loan term of 10 years.

Insurance companies and local and regional banks led the way toward getting retail deals done in 2020, according to Claudia Steeb, managing director, capital markets, JLL Americas. “They have flexibility, tend not to have significant exposure in any particular asset class and are able to arbitrage the market so when competitors pull out, they can jump in and gain extra yield for their portfolio.”