Commercial Loans Blog

Loan-to-Cost Ratio and Commercial Loans During Economic Upheaval

Posted by George Blackburne on Tue, Jul 9, 2013

When the Great Recession first began to bite in late-2007, sales of commercial properties began to plummet.  Investors didn't want to buy commercial properties when they could see the economy headed off a cliff.  For commercial property appraisers, sales comparables became almost impossible to find.

By mid-2008, new commercial mortgage lending fell by 85%; however, between mid-2007 and mid-2008, a few bold commercial lenders stayed in the market.  They did not, however, base their new commercial loans on appraisals.  Instead, most new commercial lending was based on cost and the loan-to-cost ratio.

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This proved to be a pretty rational decision by commercial loan underwriters because very few commercial properties were actually selling.  Commercial real estate eventually fell by a whopping 45%.

Therefore we can actually create a new theorem of commercial real estate finance.  During times of economic upheaval, when the stock and bond markets are getting crushed, commercial real estate lending is based more on cost rather than on cap rates, debt service coverage, and estimates of fair market value.

Let me provide an example.  The year is 2021.  Commercial real estate has enjoyed a steady bull market since the depths of 2009.  In fact, the rate of commercial real estate appreciation speeded up so sharply in 2019 and 2020 that old veterans once again began talking about "unsustainable bubbles".  The Young Turks continued to pooh-pooh their fears and poured hundreds of billions of dollars into new commercial real estate construction.

Then the rate of space absorption (new leases) began to slow markedly.  Commercial real estate sales fell by 50%.  The stock market seemed to hit a ceiling.  It just lacked the momentum to climb to new highs.

You're in your late-40's right now, and your job at your commercial mortgage company is to serve as the senior member of Loan Committee.  A wealthy and experienced developer brings in an interesting deal.  He has found a troubled bank willing to sell a near-Class A office building in booming Austin, Texas upon which the toubled bank has foreclosed.  The building enjoys a terrific location.  All it needs is some cosmetic work - say, a new fascade, new signage, and fresh tenant improvements - to restore it to its full Class A potential.

He can buy the REO from the bank for a mere $10 million.  Throw in $2 million for the upgrades, and every appraiser in town would agree that the property would be worth (fair market value) $18 million.  He's willing to contribute $1.5 million to this acquistion and renovation project, leaving your mortgage fund a first mortgage bridge loan of just $10.5 million on a building worth $18 million (58.3% LTV). 

So, do you make this loan?

Maybe not!  During times of economic upheaval, underwriting based on fair market value should go out the window.  During such times, its all about cost-cost-cost. (It's always about Marcia-Marcia-Marcia.) 

Let's look at the deal from a loan-to-cost point of view.  You're being asked to make a bridge loan of $10.5 million on a project that costs just $12 million ($10 million acquisition plus $2 million in renovation).  That's a Loan-to-Cost Ratio of 87.5%.  That's much too high.

The wise commercial mortgage underwriter should cut his bridge loan offer to no more than $9 million (75% loan-to-cost) and make the sponsor bring in $3 million to the closing table.

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Topics: loan-to-cost during upheaval