Commercial Magazine

Leave Gridlock in the Dust

Deal with changed lender expectations in this ‘new normal’ environment

By Lukas Bull

This year has been tough on commercial mortgage brokers and lenders alike. In a matter of months, lenders shifted from rapid closings, high lever-age and low rates to near gridlock. Economic uncertainty and the fear of COVID-19 cases spiking has everyone wondering when this nightmare will end. When the virus does fade, however, what will the recovery for commercial real estate lending look like moving forward?

As we begin to recover and transition into the new normal, lenders will reopen their doors, but many will have modified their program guidelines to reduce risk and maintain profitability while remaining competitive. This allows for a significant opportunity among nonbank lenders and private lending institutions.

When the country resumes a normal way of life, brokers and lenders will see an influx of high-quality borrowers looking for high-leverage loans. Yet these borrowers will be hard-pressed to get a commercial mortgage from a bank given the low-rate environment and a lack of appetite for long-term, fixed-rate debt obligations.

The private sector will have modified loan parameters but will still offer more forgiving underwriting standards and guidelines to quality borrowers than their bank counterparts. Private, nonbank lenders should see an uptick in originations. Banks are pulling in the reins and becoming more selective with their originations amid market uncertainty and the shaky outlook of certain asset classes.

Lending roadblocks

Brokers continue to deal with significant roadblocks. In the midst of this recession, you’ve likely noticed that property values dropped from what they were this past January. Why is that?

Commercial real estate values are primarily based on net operating income (NOI), or effective gross income minus operating expenses. During a recession, property owners face increased vacancy rates, late payments or no payments at all. The COVID-19 pandemic brought about another set of unique circumstances. Some jurisdictions, for example, allowed for the deferral of rent payments altogether. For the property owner, this meant that many tenants weren’t paying rent, which equated to a significant drop in NOI.

A drop in NOI thus lowers the income approach to a commercial appraisal and significantly devalues the property. Decreases in commercial-property values, however, could prove lucrative for the opportunistic investor. The well-capitalized investor will likely look to take advantage of this soft market and acquire a new investment property at a discount. This poses a significant opportunity for both brokers and lenders that can attract business from seasoned commercial real estate investors.

As the virus fades and the curve continues to flatten, what can we expect new lending guidelines and parameters to look like? Moving forward, many lenders will likely take a deeper look into the borrower’s liquid assets and post-close cash requirements will increase. Standard underwriting principles state that three months of projected PITI (principal, interest, taxes and insurance) payments must be available in the balance of borrower bank accounts.

Going forward, lenders may require more than three months of PITI to proceed with a loan. This will ensure that the lender is protected, mitigate the risk of an underperforming loan and help to guarantee on-time monthly repayments. Coinciding with increased cash-reserve requirements, many lenders will look to add in a short-term, post-close PITI escrow of three to six months until the market stabilizes. This will ensure that lenders are protected for the immediate future and mitigates the negative impact that an unforeseen spike in COVID-19 cases will have on loan performance. Lastly, loan-to-value (LTV) ratios will likely be lowered from their prepandemic highs of 80% down to a more tolerable 65% to 70% LTV level.

In the months to come, bridge loans, fix-and-flip loans and rental loans — among other short-term vehicles — should prove to be lucrative options for brokers and lenders alike. The short-term nature of these loans helps to alleviate the risk associated with 30-year, fully amortizing paper, especially with so much market uncertainty. Also, lenders specializing in these short-term loans are only implementing modest changes to lending parameters and guidelines, and are beginning to lend at near pre-COVID capacity.

Assets to watch

It is worth touching on the outlook of some of the major commercial asset types, as some will do better than others. Demand for office and retail space in the post-COVID period is quite likely to decline over the long term. The pandemic not only disrupted businesses but also fundamentally changed the way many companies may choose to conduct business going forward.

With widespread lockdowns and forced quarantines, many business owners have realized their employees can work as efficiently from their couches and kitchen tables as they can from their office desk. Similar output minus the overhead cost of office space equates to a better bottom line. It will be a no-brainer for companies to downsize if they can function remotely and cut office space out of their budgets.

Meanwhile, traditional retail was already losing ground to e-commerce prior to the pandemic, a trend that has only accelerated. Recently, notable brand names such as JCPenney, Lord & Taylor and Gold’s Gym have declared bankruptcy due to forced closures and a devasting drop in foot traffic. Storefronts that sell groceries and other consumer staples, however, will continue to be a high-performing asset class. Many other tenants will be faced with a slow recovery, occupancy restrictions and social-distancing requirements for months to come.

Without question, this pandemic has affected all commercial asset classes, but some have fared better than others. Multifamily properties remain a stable investment amid the market uncertainty brought about by COVID-19. Multifamily should remain a solid performer due to ample demand and an increased share of renters in the marketplace. Also, the average lease length for a multifamily property is one year. Property owners and managers can respond quickly to changing market conditions and price units accordingly, while other commercial asset classes with multiyear lease terms have far less flexibility.

People will always need a place to live, regardless of the surrounding market conditions. Although not recession-proof, multifamily housing is certainly more resilient to change than other asset types. That being said, multifamily assets are facing their own set of challenges. With mass lockdowns, many complexes were not legally allowed to conduct in-person tours and had to embrace virtual tours or rely on online photos to market to prospective tenants.

Also, Fannie Mae, Freddie Mac and the U.S. Department of Housing and Urban Development prevented landlords with federally guaranteed or insured mortgages from imposing late fees or evicting tenants through this past July. As of August 2020, Congress had not extended additional federal moratoriums, but an additional relief package was in the works and will likely include tenant protections through 2020.

As a broker, you are likely wondering if it is possible to come out of this pandemic in a stronger position than before. For now and into the near future, it may be difficult to find reasonable terms on long-term, fixed-rate paper, but this could lead to opportunities elsewhere. Those most likely to survive this recession will be those who are most able to adjust to a changing environment.

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This pandemic shall pass and those willing to adapt will survive. It may be a slow recovery for the commercial real estate market, but the tightened lending constraints brought about by the pandemic will ease and credit availability will increase. In the meantime, adapting to this market and exploring new loan products should prove to be lucrative for both lenders and brokers. ●


  • Lukas Bull

    Lukas Bull is a credit analyst with Prime Commercial Lending, located in Albany, New York. He works with an ever-growing network of brokers to advise and facilitate the transaction of permanent commercial mortgages ranging from $100,000 to $5 million, with unique programs for both investors and business owners.

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