Underwriting? Beware the Cash-Flow Constrained Deal


The local New York City mortgage market is facing a new obstacle which has yet to surface on the radar of many market participants. Since the Great Recession, cash flow has been the primary metric by which to measure credit quality. In a market like New York City, where capitalization rates have been low for a decade, this has meant that loan-to-value ratio, a historically significant metric which continues to be key to underwriting in other markets, has largely been made irrelevant. In sharp contrast to the pre-recession landscape, almost every deal done in New York in the last 10 years has been constrained in size by its available cash flow (or at the least, its pro forma cash flow) to a loan-to-value ratio in the range of 50 to 70 percent.

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Because of these underwriting constraints, and the low loan-to-value ratios that they imply for low capitalization rate deals, almost every acquisition made in New York City in the past five to 10 years has a loan which was underwritten to a maximum size based on the ratio of available cash flow to the cost of the debt. The low leverage points make these deals appear to be conservative, but they are actually very aggressive on current cash-flow underwriting standards

The unintended consequence of this underwriting is that the borrowers in these transactions will face significant headwinds when it comes time to renew their loans. On the other side of those transactions, lenders are going to face downgraded loan ratings as their loans age. The reason for this is that the two variables in the underwriting equation are both moving against the deals.

When underwriting a cash-flow constrained deal, the ratio being evaluated is the ratio of the cash flow to the cost of the debt. On the one hand, cash flow is shrinking. New York City multifamily and retail rents have been stagnant or declining. Additionally, real estate tax assessments, water bills, and other costs have been rising. The result of these factors is a hit to the top line revenue and a growing expense line. On the other side of the ratio, as interest rates are rising the cost of debt service has been rising as well. The combined effect is a ratio that no longer meets current underwriting standards

The result of this confluence of decreasing top line revenue, increasing expenses, and rising rates is that many loans which were made at the maximum level in the last few years are now no longer able to meet the required debt service covenants at current interest rates and are unlikely to be eligible for refinance at their current levels. Because of the low loan-to-value ratio of most of these deals, it appears there is sufficient equity in the transactions to prevent a wave of foreclosures. More likely than a foreclosure crisis, banks will face reduced profitability as they are forced to take larger reserves and will be under pressure to move the non-conforming loans off their books, potentially at a discount. Borrowers who have assets up for refinancing will find themselves forced to consider a stark choice: come up with fresh equity or sell. For many syndicated holders who do not have the leeway to make a capital call from their investors, a sale will be the only option available to them. Depending on the state of the market and the rate of sell-off, they may face discounted sale prices while other equity investors with cash on the sidelines profit from the distress of those with maturing loans and low cash positions

A strategy for addressing this risk in the long term may involve changing underwriting standards and the associated assumptions about rent growth, expense growth, and interest rates. In the short term, a solution is more elusive. Changing the underwriting standards for non-conforming loans approaching rollover creates the risk for the lender of creating assets classified as Troubled Debt Restructurings, a universal red flag to both regulators and investors. A more likely outcome will be an increased effort by lenders to find technical issues which form a pretext for non-renewal of loans, forcing the issue into the hands of borrowers. Whatever course of action is chosen, it seems we are poised to see a rise in transaction volume in the coming year. Investors should be ready to transact either with banks or with owners opting to sell instead of recapitalizing their holdings.

Andrew Dansker is a first vice president of finance at Marcus & Millichap. He can be reached at: adansker@ipausa.com