The U.S. commercial real estate market is set to take off in the coming months. Investors have tremendous amounts of capital to deploy and there is pent-up demand to complete real estate deals across most property types. This suggests that commercial mortgage brokers will be busier as the economy and market recover.
Another trend also bodes well for commercial mortgage brokers. Given the uneven impact of the COVID-19 pandemic on commercial properties, many lenders are trying to diversify their loan portfolios to avoid the risk of remaining overly exposed to one particular type of property. The pandemic has effectively forced lenders to be more flexible to lend on various rental-property types.
That said, there still is uncertainty and some caution exists. The market has changed and this affects how commercial mortgage lenders evaluate assets. Lenders are tracking not only the macroeconomic trends that affect the market broadly but granular details at the property level and within individual markets.
Uneven impacts
Some property types have clearly benefited from pandemic-induced market shifts over the past year. According to Deloitte, e-commerce companies, grocery stores, pharmacies and warehouses have experienced a surge in demand, given that more people are working from home.
Among U.S. real estate investment trust (REIT) property indices, data centers, cell towers and industrial properties saw double-digit growth in values immediately after COVID-19 emerged in March 2020, whereas multifamily, office, retail and hotel asset values fell significantly. For example, data-center REITs had a 34% year-over-year gain in value as of April 2020, whereas hotel and retail REITs declined respectively by 53% and 48%, Deloitte reported.
In evaluating loan requests, however, lenders must try to understand where the changes are occurring, and whether they will have a lasting impact on the performance of these assets and their values. These changes are uneven across property types and some assets could see longer-term impacts. For example, hotels were hurt across the board in every area of the country and suffered the most severe drop in values. But the hospitality industry also is expected to recover quickly once vacation and business travel rebounds.
The midterm outlook for hotels is quite favorable despite the sector’s recent struggles. Multifamily is similar in this regard. Some apartment owners have lost income while being forced to defer rent payments and not evict nonpaying tenants, but the long-run viability of apartment buildings seems assured given the huge pool of potential renters from the millennial and baby-boomer generations.
On the other hand, office-property fundamentals were not hurt as badly as hotels in the short term, but the sector’s long-run outlook is more uncertain given that many companies are allowing their employees to work from home. This is making it more difficult to evaluate the future performance of the traditional office.
Performance metrics
All of these market changes are evolving and affect how lenders view assets on a broad basis. As the pandemic subsides, of course, the demand for specific types of rental properties may continue to change, and mortgage brokers should pay attention to these changes to gauge how a lender may react to a proposal. Aside from broad-based market trends that affect all assets within a sector, some other important performance metrics at the property and market levels are worth mentioning.
First, changes in lease terms are on the minds of lenders. The pandemic disrupted businesses across the country, forcing many tenants to shutter their stores for months. This has affected income streams along with leasing trends. In the office sector, there’s evidence that companies are reluctant to sign long-term leases. As companies have reevaluated their space needs, there also has been a surge in subleasing activity.
Meanwhile, apartment owners have been unable to collect rents or evict tenants for nonpayment. In some cases, landlords and tenants have been making special arrangements or altering their original leases. Flexible lease terms may become the more normal course of business. Whatever the final outcome, lease terms on rental properties will ultimately impact the lender’s ability to recoup its capital. So, it’s important to stay on top of the trends.
In the special case of the single-family rental market, you also should get familiar with the price-to-rent ratio. This compares an area’s gross annual rents and home prices. This can inform investors on the prospective demand for single-family rentals in a particular market.
For example, if this ratio is high, it can indicate higher demand among renters. In contrast, if the ratio is low, it suggests that it is cheaper for people in the market to buy a home rather than rent, creating lower demand for rental housing. Of course, this won’t be a rock-solid number that will always tell you whether to proceed with an investment, but it can tip off investors to emerging housing bubbles. Lenders often use this ratio to gauge the loan risk of a single-family rental home.
Looking ahead
Commercial mortgage lenders are remaining somewhat cautious due to the ongoing pandemic. Despite the successful rollout of multiple vaccines, the health crisis is not yet over. There remains a risk of a new surge in cases. If another wave of COVID-19 hits the country, areas of the economy could shut down again.
In calculating the riskiness of loans, lenders must factor in the possibility that income streams could be unstable for some time. Fortunately for commercial mortgage brokers and their investor clients, lenders have tended to not pull out of markets and are expanding their horizons. For many lenders, the pandemic has had the effect of opening their eyes to new possibilities. Although they are cautious, they are approving loans for asset types and projects that were once outside their comfort zone.
After all, to minimize the risk of a shock to their portfolio, the smart businessperson will naturally want to diversify their holdings. As a hedge against risk, lenders are looking at different types of assets that they may have never considered before.
This bodes well for the commercial mortgage broker, who may be pitching a hidden gem of a project that the typical lender once might have automatically disqualified. Post-pandemic, the way that mortgage lenders think about properties and evaluate loan requests will continue to change, even as the world around us opens up. ●
