How Owners Can Balance Improved Credit Availability with Ongoing Underwriting Constraints

April 2024

Lenders are Eager to Do Deals with Some Important Limitations

Over the last six months, owners and lenders have been adjusting to the new normal in the commercial real estate capital markets brought on by higher interest rates and compressed asset valuations. Challenging conditions have prompted some lenders, especially traditional banks, to moderate financing activity in favor of a wait-and-see approach. As we move through 2024, the dynamics that caused a rude awakening in 2023 are becoming manageable in the eyes of many capital providers, and credit is becoming available – with a few caveats.

Many lenders are derisking and focusing on protecting against the downside throughout the underwriting process. Unsurprisingly, they continue to place emphasis on gaining a thorough understanding of the owner, the asset, and the business plan. The level of caution is resulting in financings with some restricting conditions.

First, lenders continue to emphasize market comparables when reviewing business plans and underwriting loan packages. This has forced owners to design business plans that are grounded in market data. For many owners, this means grappling with the fact that forward-looking rents may not be as strong as they were during previous financing initiatives, and at the same time, operating expenses are coming under pressure across the industry.

Second, some banks have shifted to underwriting based on untrended rents, which means they assume static rent growth over some or all of the holding period. This conservative methodology reflects lender pessimism on rent growth in coming quarters. Owners should be aware that while lenders are open to extending financing, the loan amount could be reduced if the lender chooses to incorporate untrended rent assumptions into the analysis.

Third, while lenders have continued to underwrite loans based on in-place and/or stabilized debt yields, the increase in Treasury yields has resulted in the debt service coverage ratio (DSCR) becoming the constraining factor for many loans. Recently, some owners have been surprised to learn that a 1.25 minimum DSCR on a fixed-rate loan priced at 250 bps over the 10-year Treasury rate with a 30-year amortization term is the equivalent of a 10.04% debt yield!

Key Considerations for Owners Expecting an Upcoming Financing 

Owners with upcoming financing needs should take a few steps to jumpstart their loan process. The most important thing an owner can do is be proactive and work with a capital expert to understand the current due diligence requirements that will be needed to kick off the underwriting process. Early discussions should also focus on identifying potential underwriting risks, understanding how these risks could impact the financing package, and discussing steps that can be taken to maximize structuring and pricing benefits for the borrower.

Owners should also be aware of the data that is gaining importance in the underwriting process. Lenders are focusing more heavily on the impact of economic and market dynamics on rents and long-term asset performance. For example, in the self-storage space, local population trends, unit supply growth, current occupancy, and storage units per capita are some of the metrics that have taken on more weight. Regardless of property type, lenders are focused on demand factors, supply metrics, rent trends and concessions, and property-specific competitive advantages.

Finally, owners should be prepared to produce a comprehensive business plan that is supported by data specific to the trade area where the physical asset is located. Owners stand to obtain more loan quotes and unlock more financing options by demonstrating that they understand how the subject property stacks up against comparable assets and how the asset can remain competitive and prosper over the holding period.

How to Mitigate Execution Risk

When seeking a financing solution, owners benefit by working with a capital expert with a deep understanding of the current market and the underwriting elements that lenders emphasize. Our team maintains relationships with an extensive number and wide variety of capital providers to meet the needs of a diverse client base. We are actively leveraging these programs to source financing solutions for our clients that meet their unique objectives.

Relationships are key in the ability to serve our clients, and our team is constantly striving to build and foster additional lender relationships. In a testament to our commitment to providing the industry’s most comprehensive capital solutions, in the first quarter of 2024, our team sourced ninety-three additional lending sources that could meet our clients’ needs thereby increasing the competitive lender set to provide tangible benefits to Talonvest clients.

Final Thoughts

In recent months, it has become clear that capital is available across asset classes subject to underwriting constraints that lenders have implemented to address perceived market risks. For owners this is an important time to remain informed on the key underwriting trends prevailing across the capital markets landscape. With the right level of planning and partnership, owners can navigate these waters successfully and achieve their business objectives.