Many banks today are satisfied to underwrite real estate secured loans on just two metrics: debt-service-coverage ratio (DSCR) and loan-to-appraised value (LTV). Banks typically approve credits above 1.20X and below 75% LTV – with many loan-specific factors that may skew these acceptable levels either way. For competitive reasons, we see some banks who are dipping to 1.10X DSCR, and some deals are approved at 85% or even higher LTVs. However, in today’s business cycle banks must alter their acceptable underwriting standards in two ways: 1) add debt yield as another metric, and 2) rethink the minimal acceptable project DSCR. We will consider the minimal project DSCR in today’s blog and cover the debt yield topic in one of our blogs next week.
Why DSCR and LTV are Misleading
Historically 1.20X DSCR and 75% LTV were comfortable safeguards for community banks. Credits that started at those levels were unlikely candidates for special asset management. However, in today’s economy, the 1.20X and 75% LTV are highly misleading measures, and the reason for this is the relapse of commercial real estate cap rates. Cap rates have declined for a number of reasons including an extraordinary amount of monetary stimulus, low-interest rates, hyper-liquidity in the banking sector and the long period of economic expansion. Below is a graph showing national cap rates for all categories of real estate across the country.
The current national average cap rate for all categories of real estate is 5.46%, and that compares to an average of 7.5% and a maximum of 10.32% for the 15 years considered in the graph. Cap rates for different categories of real estate vary – with hospitality currently at the higher end at 7.17% and multifamily at the lower end at 4.77%. However, the trend is obvious for all categories of real estate – cap rates are at or near all-time lows. Why is that a concern for lenders? The obvious answer is that if cap rates rise in the future (which they will) the value of the real estate collateral will decline, and the lender’s secondary form of repayment erodes. But the less obvious answer is this: there is only one source of repayment, and that is cash flow, and increasing cap rates (decreasing real estate values) have a different impact on lenders depending on the starting or expected DSCR. In a lower cap rate environment, banks must expect a higher project minimum DSCR to have the same quality credit versus a higher cap rate environment. Below is a graph showing the sensitivity of different DSCR loans all starting at a 6% cap rate (5% fixed rate loan on a 25yr amortization). The lower the starting DSCR, the faster the LTV reaches 100% as cap rates increase.
In other words, loans with 1.20X DSCR will experience both collateral coverage shortfall and cash flow impairment if cap rates move from today’s ultra-low levels to just historical average levels. The 1.20X DSCR, 75% LTV loan in today’s 6% cap rate environment becomes a 95% LTV loan if cap rates move to a historical average of 7.50%, and the same loan becomes 106% LTV if cap rates move to recession levels. This all occurs without any change in NOI or interest rate levels. Any decrease in NOI or increase in interest rates degrades credit quality further.
By contrast, the 1.50X DSCR loan will not break 100% LTV until cap rates rise to just over 10% (above standard recession cap levels). The issue in real estate lending today is that while LTV and DSCR are highly correlated metrics (which is bad in that they measure the same variable – cash flow), and both are under pressure in a competitive lending environment (lenders are accepting lower DSCR and higher LTV). Loans booked today with minimal cash flow cushion in low cap rate environment and low-interest rate cycle, are the worst possible combination for banks. Some banks are originating loans with very little room for error – low-interest rates, low cap rates, low DSCR and high LTVs all point to highly vulnerable credits from every conceivable angle.
Banks should be directing more focus to the interplay between DSCR and LTV because both are driven by cash flow (NOI). In this late period in the business cycle, smart lenders are substituting lower yield for higher cash flow. Further, the relationship between cap rates, interest rates, DSCR and LTV are all conspiring to make real estate lending especially perilous. Furthermore, community banks should embrace one additional metric that national banks have used to measure the health of their real estate portfolios – debt yield. In our future blog, we will analyze how debt yield can help community banks properly measure the interplay between cap rates, interest rates, and cash flow.
Submitted by Chris Nichols on February 06, 2019