The One CRE Underwriting Metric You Are Likely Not Using, But Should

More Accurate Commercial Real Estate Underwriting
More Accurate CRE Underwriting

Whenever your bank is looking at underwriting commercial real estate (CRE), you are probably looking at a variety of macro factors such as rent and occupancy trends, absorption, and capitalization rates. However, since we see hundreds of underwriting packages a month from a variety of banks across the country, it is rare that we see banks, and even borrowers, adjust rents for new construction. In this article, we present our methodology, data, and adjustment factors that banks can use to have more accurate underwriting.

 

Lease Rates and Construction Supply Correlation

 

It is no surprise that rents and supply are inversely correlated. Build more units of something, and as supply exceeds demands, prices will adjust downward. This is at the heart of almost every real estate cycle as developers tend to overbuild towards the end of the cycle, often resulting in more vacancies and lower rents that banks underwrite.

 

To quantify this risk, we first define new supply as the total square footage of a product (office, retail, industrial, storage, hospitality and multifamily) being built as a percent of existing supply. After looking at CoStar data going back to 2000, it usually takes between 12 and 30 months for a new supply to impact rents. As a rule of thumb, and for the sake of analysis, we use an eight-quarter lag which is more accurate for most bank projects to include a 12-month construction process and a 12-month lease-up/tenant improvement/stabilization effort.

 

Banks should adjust this number depending on the project, with more straightforward construction such as industrial properties taking a shorter amount of time to hit the market while office and multifamily tend to be a little longer. In addition, larger projects tend to impact the market in a shorter amount of time, while many smaller projects have less of an impact.

 

Making The Adjustment

 

We can generalize the data into a downwardly sloping linear equation that starts at about 2% and goes to negative 2.5%. Another way to look at this is with the chart below. Here, in general, if you have 1% of new supply coming on, that is still not expected to keep up with the market, and so rents should increase about 1.75% absent of any externalities. Comparatively, if you are a booming construction market and you are adding 4% of new supply, you can expect rents to drop 1%, no matter what the developer says. 

 

Graph to Adjust Rent Given Unit Supply Growth in CRE

 

Putting This Into Action

 

Banks need to be sure to adjust their rent projects not based on history but projected into the future. Commercial real estate is a dynamic market, yet many banks analyze the risk as though it were stable. Markets such as Seattle, Houston, Cleveland, Richmond, Las Vegas, Raleigh, Dallas, and Oklahoma City still show favorable rent to new supply ratios that all point to higher future rents net of supply. Conversely, markets such as San Antonio, Miami, Orlando, Portland, Austin, New York, Nashville, Milwaukee, and Orange County (CA) all show supply growth that points to lower future rents.

 

If you are not adjusting your lease rate and rent projections to take into account new construction, consider it to get a more accurate picture of the all-important expected cash flow for a property.