Impact of Capital Markets on Commercial Real Estate Values
The economic downturn is reducing demand for commercial real estate, and vacancies are expected to rise moderately, though they will remain in a healthy range. Nonetheless, investors are facing higher borrowing costs and have access to less leverage, which negatively impacts values. Leverage is one of the prime motivators for investors to purchase real estate for a few reasons. To start, it allows investors to control a larger property than they otherwise could if they had to pay all cash, thus increasing their return on equity. Leverage also allows investors to spread their equity across multiple properties, minimizing their risk through diversification.
When there is uncertainty in the markets, lenders hedge their risk by building in greater cushion in their underwriting, including increasing 1.) Debt Service Coverage Ratio (DSCR) requirements, (2) wider loan spreads, (3) and decreasing Loan-to-Values (LTVs).
- Rising DSCR – Prior to the capital markets shakeup, DSCR was at an average of 1.1:1, which means lenders required $1.10 in NOI for each $1 in debt service. Lenders today are mitigating risk by requiring NOIs are 1.25:1 greater than debt service.
- Wider Loan Spreads – Competition among lenders forced spreads to historically low levels in 2006 and early 2007, with the average falling to 100 to 110 basis points over the 10-year Treasury, which at the time was around 4.65 percent. The 10-year Treasury has retreated to the mid-3 percent range, but lenders are pricing in more risk, pushing loan spreads to an average of 275 basis points of the 10-year Treasury.
- Lower LTVs – Approximately one year ago, LTVs were 75 to 80 percent. The rapid price appreciation cycle has ended, and tighter credit markets are encouraging lenders to become more cautions. As a result, LTVs have decreased to the 65 to 70 percent range.