Late-Cycle Lenders Proceed With Caution

At MBA's CREF 2020 Conference, lenders said high valuations and rent regulation are just two of the many risk factors that impact credit decisions today.
Risky Business: Late Stage Cycle Conversation on Credit, Valuations and Underwriting panel at MBA

How do you lend money into a market and an economy that may be heading into a decline? The answer: very carefully.

The economy is still showing signs of strength and real estate capital is plentiful, but the risks—including weakness in manufacturing spreading to other sectors, trade policy uncertainties, a $23 trillion trade deficit, a forecasted $1 trillion federal deficit, constrained infrastructure spending, a stock market correction, a tech market bubble, geopolitical risks, the U.S. national election and low short-term interest rates—are mounting, noted moderator Kelly Wrenn, partner at the law firm of Ballard Spahr.

“There is a lot more discussion around conditions than even a year ago,” said UBS Managing Director Chris LaBianca during a panel discussion titled “Risky Business: Late Stage Cycle Conversation on Credit, Valuations and Underwriting” at the Mortgage Bankers Association CREF 2020 Conference.

In light of the market’s unpredictability, KKR has shifted its bridge lending to assets that can complete a “lighter” transition in 18-24 months vs. assets that will take three to four years to complete a complete renovation or expansion, said Managing Director Joel Traut. “That means a little more turnover in our portfolio but that is something we are okay with,” he said.

Further, while some lenders have entertained more interest-only components, relaxed cash management requirements, extended terms, etc., KKR has also remained “very vigilant” about structure. “If things get too unwound, we just don’t participate in those processes,” Traut said.

TD Bank is being very cautious due to high valuations and all the other risk factors out there today, said Greg Gerken, executive vice president & head of U.S. Commercial Real Estate Lending. “We don’t know what the top is,” said Gerken. “At this point in the cycle, we are looking at not only what cap rates are but how durable is the cash flow.”

Also, as a balance sheet lender, Gerken said, they are looking at loans today as if they are making an investment. “We have to think about this property with a lense that, frankly, as a banker I never thought I’d use,” he said. “It’s not loan-to-own but loan-to-what-if and making sure we are not underestimating everything that has to go right.”

LaBianca said now is the time for lenders to return to basic principles like being market savvy so they can foresee the things that may signal trouble. Some of the new hot markets, like Nashville, may become overbuilt. Others—like New York—are dealing with regulatory challenges.

Lessons Learned

But haven’t the real estate capital markets generally been more cautious throughout this cycle?

They have and haven’t, noted LaBianca. When you look at the average leverage (58 percent today vs. 75 percent in 2007), debt yields (11 percent today vs. 8.5 percent in 2007), and debt service coverage (1.99 for insurance companies and 2.3 for CMBS today vs. 1.2 in 2007), the industry has learned the lessons of overleveraging. The percentage of IO loans (about 82 percent today) could be a sign that the industry has gone out of bounds, but the leverage on those loans is 58 percent on average.

Net operating income, however, has not risen with valuations, indicating lenders were not as they thought. “Maybe what we thought was more conservative wasn’t,” said LaBianca.

Room to Fall

But, despite some trouble that may be on the horizon, commercial real estate still has a considerable cushion, said LaBianca: “This run has been so good for so long, and where property prices are, even if there is a 20 percent correction, you’d be back to 2016 and still above 2007.”

Romina Padhi, vice president & senior credit office for Moody’s Investor Services, noted that prices for some CMBS issues (smaller markets and student housing, for example) have already dropped. “It really depends on the property, the sponsor and the market,” she said.