With today’s headlines warning of a deepening real estate crisis and investors increasingly concerned about receiving their interest payments, one wonders how to justify funding new loans in a negative real estate environment.
A downturn in the market is a double-edged sword: for loans underwritten before the downturn, the risk has increased, while new loans – written to current realities – offer new opportunities. The challenge for lenders today is to recognize evolving real estate values and apply those new facts in structuring a common sense approach to hard money lending.
Four fundamental shifts in the marketplace that must be recognized:
1. Real estate values have been repriced.
2. Real estate values are continuing to be repriced.
3. Various real estate markets are influenced by different realities.
4. The sponsorship of a project carries greater importance and more responsibility.
Homes are worth less than they were one and two years ago. Loans underwritten today should not be based on appraisals or purchase prices that are not current – certainly within the last 60 days. Moreover, a prudent lender would want to update any appraisal with the most recent comparable sales possible prior to funding – just to see the most recent trends.
An investor recently complained to me that lending in today’s market is like trying to catch a falling sword. What the lender meant, of course, is that even if one lends to today’s reality, tomorrow maybe even worse. Market trends must be taken into account – not just where the values are today – but where they may be tomorrow. It is of course difficult to predict the future, but a cautious lender would, at the very least, research and recognize current trends.
The recent change in values is not universal. Single-family homes are suffering declines in values due to inflated prices fueled by a combination of the “investor herd” and lax lending standards. This story is well known and supplies the fodder for today’s doom-and-gloom headlines. Asset classes other than single-family homes are a different story. Industrial and retail properties appear to still be in strong demand. Office properties seem overbuilt, yet some areas are stronger than others. It is important then to recognize that there is not one real estate market, but many. Good underwriting recognizes this fact and accounts for trends and realities as they apply to each sector and region.
When interruptions occur in capital supply, the sponsorship behind a loan becomes increasingly important. Capital flow from banks and other institutions is becoming evermore unreliable. This means that the exit strategy contemplated at the time a loan was funded may be delayed or abandoned. In such a case, the guarantor and/or sponsor of a loan will have to “step up to the plate” and make out-of-pocket payments he may not have counted on. If the borrower’s net worth came from equity in real estate, then that net worth and ability to tap into it is probably diminished (at best) in a declining market. Income from sources other than real estate provides diversity that helps mitigate the effects of capital interruptions in volatile times.