Real Insight. Real Estate.

As we round out 2009, one of the most interesting top 10 lists we could conjure deals with all of the various changes in the capital markets as it pertains to the commercial real estate sector.  The availability of capital has diminished significantly, and for capital that remains available, return requirements, interest rates and loan terms have all changed substantially.  Let’s take a look at the top 10 changes:

10. Shorter amortization periods for fixed rate loans by 5-10 years - Many banks have cut back the amortization schedules on loans from 30 years to 25 years, and from 25 years to 20, or even 15 years in some asset classes. Shorter amortization periods means more expensive annual debt service payments.  This of course has a subsequent effect on cash flows as well as tradition debt service coverage ratios.

9. More equity deals being structured with debt-like components - Equity partners have shifted much of the weight of their return to their preferred position.  This, of course, means that they face losing significant upside on strong deals.  However, they seem to be happy to trade that upside return potential for greater security of their minimal required return.

8. Capital sources mitigating portfolio risk by doing smaller deals - If you are going to make a bad loan or investment, the only thing that can make it worse is by exposing a significant chunk of your portfolio risk to one huge deal.  As more and more capital sources got burned on huge deals (i.e. Citigroup loans to Dubai World  or Tishman Speyer with Stuyvesant Town/Peter Cooper Village) it sparked changes across the entire capital market landscape.  Many lenders (and brokers for that matter) have been concentrating on smaller deals for different reasons.  Lenders want to mitigate portfolio allocation risk by spreading dollars across a greater number of deals.  Brokers know smaller deals have a greater likelihood of getting done for this reason, and thus their probability of a payday increases.

7. Loan-to-value ratios dropping by 10-20% across the board - Banks typically make loans at some percentage of the appraised property value as a way to mitigate risk against deterioration in property value as a way to protect their investments just in case the market tanks or the property loses significant income. LTVs for many banks were in the 75-80% range as of a few years ago.  However, as market conditions deteriorated, property values sunk below the face value of the loans on the properties themselves.  Not only were borrowers entire equity positions wiped out, but banks could no longer sell foreclosed assets to recoup their invested dollars. Thus, the ratios to which they will lend against property value has dwindled from the 75-80% range to the 60-70% range….and that’s before mentioning that appraised values have plummeted as well.

6. Equity partners wanting to see more skin in the game - Equity partners are now requiring the sponsor of the deal to have as much as 30% of their own equity in any single transaction.  In ‘06 and ‘07, many deals got done where the sponsor had as little as 5% of their own equity in a project.  This has obviously put a squeeze on sponsors ability to make deals happen.

5. Non-recourse loans essentially disappearing - The market for non-recourse loans have not evaporated completely.  There are still life companies who will lend on a non-recourse basis. However, they are generally for larger loans for good projects with sponsors with immaculate track records at lower than average LTV ratios (55-65% range) as a way to further mitigate the risk of not having recourse.  The regional banks that used to consider non-recourse loans have almost entirely disappeared.  What is worse, is that most have gone from considering non-recourse loans, to not considering any loans that aren’t full recourse.  There are those who will consider some level of partial recourse, but those banks are fewer and further in between.

4. DCR ratios rising between 5-15 basis points across the board - Debt coverage ratio is defined as the ratio between net operating income and debt service (while cash flow is NOI less debt service).  Similar to the logic with LTV ratios, lenders typically want some type of risk protection between the income a property generates and the debt owed on that property.  Typically, this is done to ensure that in the case of a unforeseen event (i.e. a tenant leaving/going bankrupt or unexpected capital expenditure or property maintenance costs) there is still enough NOI to service the debt.  In the past, lenders required as little as a 1 to 1 ratio (though most were in the 1.15 or 1.20 to 1 range).  Now, minimum DCRs are in the 1.25 to 1.3 to 1 range. The higher the DCR requirement, the less debt can be supported by the property.

3. Yields rising  between 1-3%, return hurdles rising between 5-10% - Lenders now require higher yields on the same risk profile.  Similarly, equity partners are looking for higher returns largely on the assumption that they will be able to buy distressed deals sometime in the near future at an extremely low cost-basis.  Whether that assumption will hold true is anybody’s guess, but that assumption of what is coming down the pike influences their return requirements today.

2. Construction loans disappearing - While this may be a blessing in disguise, given the current state of the economy, the absence of construction lenders have crippled many a developer. With many failed construction projects and general perceived lack of demand from prospective tenants, lenders have all but closed up shop in regards to their construction loan portfolios.  After having been saddled with half completed projects, land and largely vacant projects, who can blame them.  Lenders who are making construction loans (or loans that would fall into their construction loan portfolios) do still exist.  However, they will require either loan guarantees from sponsors with significant liquid net worth, or for the construction project to be significantly (i.e. 75% or higher) pre-leased.

1. The CMBS market collapsing/all balance sheet lending - With absolutely no demand for CMBS securities in the secondary market, lenders stopped originating CMBS deals by the end of 2008.  Essentially, an entire financing product has dissappeared from the market.  The universe of available debt is now restricted only to loans that the lender will keep on thier balance sheet, which has crippled the credit market.

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