Is Your Bank Looking Forward Enough When Underwriting Commercial Real Estate?

Using Data For Forward CRE Projections

One of the classic mistakes that most of us made back in 2006 is not taking a forward looking view of credit. We underwrote credits based on current debt service coverage and current loan-to-values, instead of using forward values. This was a mistake, as had we looked ahead, we would have seen a large portion of the economic downturn.

 

This is happening again and we have a perfect example to underscore our point here in Florida. Take the infamous South FL condo market. Here, condo sales just hit a near-record high of $730 per sq. foot. Not only are sales up, but rents are up as well. If you underwrote a condo development loan or even a multifamily housing project you would see a history of rapidly increasing sale prices and rents. For multifamily, for instance, we are looking at a project right now that current debt service coverage would be 1.18x. Given recent comps, this project has a 79% loan-to-value ratio when completed. The problem is, the odds are against either the cash flow coverage or the LTV happening. This project looks great when you look in the rearview mirror, but horrible looking forward.

 

The problem with real estate developers is that they are a creative and risk tolerant group and will build almost anything as long as they can get financing. The other characteristic of developers is they all get the same idea to build as the market heats up. This is what is going on in South Florida.

 

Right now, 171 developers have 208 condo projects going on in South Florida that total almost 30k units. We know this because we can look at public records and databases. That is a lot of new units and if you take the current inventory, vacancy rates, absorption rates and population growth you arrive at the conclusion that supply outstrips demand by early next year. Unless the rate of households coming into the market or at least investors picks up from its current pace, the odds are that rents will likely come down. For the condo project and for our multifamily apartment building, this means lower rents and lower value. This is the exact opposite of what is in the developer’s projections. The developer’s projections never took into account all the other projects coming on line.

 

In fact, using a couple simple statistical tools, we can project how much rents will likely change if the current relationships of the above mentioned variables hold constant. For our multifamily project, this drops cash flow to about 1x coverage or to the point we would regret lending. These projections are by no means fact, but they are the most probable case given the new supply.

 

If they don’t already, Investment real estate underwriters should take the time to pull public data and to see projects that are newly completed, under construction, planned (approved) and proposed (before planning). This allows lenders a more forward view of the market and allows a more accurate projection of available units, absorption rates, net effective rents, and ultimately, cash flow. By looking ahead and leveraging the available data, banks can get a two to three year window of the future to make their current underwriting more valuable. 

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