This morning as I write, major world events swirl around. The Coronavirus’ impact seems to grow at exponential rates. Yesterday, Italy decided to lock down their entire country and this morning was providing relief for those with mortgage payments. I have friends who were to travel to Israel yesterday whose trip was cancelled with the new quarantine there. The news is flooded with various health tips and suggested restrictions on travel, self-imposed or other-imposed quarantines, and suggestions to weather business disruptions. Even a shopping trip this weekend in an area of the country that does not have one reported case, yet, revealed a run on various staple items, cleaning supplies, and sanitizer. As a business, if you have not had a conversation on how you can operate with most of your employees at home, you better plan for this possibility.
Then on Sunday, we saw the world oil markets collapse over a dispute between Saudi Arabia and Russia on production limits. The Saudis opened the spigots and we witnessed one of the largest drops in oil prices in a day in history. We also saw the biggest point drop in the DJIA on Monday, falling over 2,000 points throughout the day. The cattle and grain markets are showing substantial downward trends. Consider what also is happening to the bond market. The 30-year US Treasury opened and closed below 1% yesterday. This has never happened in history! This also is a major drop from the already low rate of 2.33% at the first of the year and shows just how fast markets can move.
Time will only tell if the events we see now are a short term dip and things will bounce back to a more normal range, or if we are in a large crater which will take a long time to return to rates closer to what we thought as normal at the first of the year. In any case, consider other things which could disappear: your net interest margin and good commercial loans.
If you have not had borrowers request lower interest rates on their loans, expect it to happen soon. We have been fielding requests on both performing and also non-performing loans to drop their rate to match what is happening in the market. (It is interesting that the lender is not expected to go to the borrower and ask to raise their fixed rate when the market swings the other way!) Commercial real estate conduit loans for office, retail, or industrial properties are priced at a margin of 140 to 290 bps over the 10-year SWAP or US Treasury. With the current market, this would result in rates from 2.21% to 3.71% locked for 10 years to the borrower. We don’t have many in the credit union and banking world who want to play in that rate sandbox, yet.
This can make the most attractive loans in terms of performance and low risk in your portfolio, vulnerable to the refinance risk with another institution. On the credit union side, this risk is more pronounced as there are very little prepayment penalties on loans—federally chartered CUs, by law, can only charge these on a government guaranteed loan that allows for these, and generally these are extremely rare in the industry anyway—and there is very little use of interest rate swaps or caps to protect the interest rate margin of the lender. Overall this law and industry practice has left institutions’ balance sheets in a very unstable position at times like this.
As you look at new requests and protecting your lending assets, consideration should be given to the property type. Multi-family lending is in very high demand, so good apartment loans may see spreads 10 bps lower. Hospitality loans tend to start at 50 bps higher. Also, the market will take a higher LTV on an apartment or office with strong credit tenant while wanting a lower LTV for properties which are riskier. Multi-family may get you into the 75-80% range, while a hotel or property with riskier tenants may be closer to 65%.
Another risk to the lender is to rely on debt service coverage ratios at this time in underwriting. With rates as low as they are, when you use a market rate, it is very easy for anyone to hit the 1.25 or higher threshold. But if you leverage a deal at 4% for 5 years up to a level that matches a 1.25 threshold, if the rates rise higher after the five years and the performance has not improved, then you may have an underperforming credit. One option is to underwrite the credit using a phantom rate. An example of this may be 6.5% or 7% today as you properly size the debt.
When rates are this low, conduit lenders tend to throw the DSCR out the window and use a calculation called the debt yield. This takes the net operating income divided by the loan amount. What this tells the lender is if he is able to operate the real estate just as the borrower has operated it, this is the rate of return expected on the amount of debt. The debt yield threshold will be lower on multifamily and office with a good credit tenant and higher on properties with weaker tenants or hotels. Note that debt yield takes out the cap rate to figure a value for the property. It also takes out the interest rate or amortization on the lender’s loan. It only looks at how large the loan is compared to the NOI. Astute commercial lenders want to make sure that low rates, low cap rates, and high leverage never push real estate valuations sky high and create another lending bubble.
What is an appropriate debt yield? I would start with something in the 9-10% range. Some lenders will go to the lower end of the range or maybe even as low as 8% on very high-quality loans. Loans in smaller rural areas or those with a higher risk profile will have a higher debt yield.
At times like this, it is important to view the landscape and make wise lending decisions. It is not a time to give away the store and you may have to let some credits go. Hopefully, there are others out there who will take your riskier deals. Perhaps when all the dust settles, you have a portfolio that is stronger.