The graphs below detail the trends in Commercial Real Estate (“CRE”) prices and CRE capitalization rates. Note that, as of data through the fourth quarter of 2016, CRE prices are noted to be at historic highs and CRE cap rates are shown to be below pre-crisis levels (per CoStar, from the Winter 2016 Supervisory Insights issue).
The trends of the two graphs, viewed in comparison, is logical given the price and capitalization rate relationship. Decreasing capitalization rates and increasing prices may prove to strengthen, at least temporarily, portions of the existing portfolio; however, new originations may be subjected to additional risks as it is unclear how far acceptable investor yields for CRE will fall in a rising interest rate environment. Rising interest rates could deter CRE investing through increasing financing costs as well as making other investment asset classes more attractive due to higher yields.
Conservative and prudent underwriting for CRE projects can include a stress test of market capitalization rates to determine the effect on property value. Escalating rents (and increasing NOI) also help to offset potential changes in investor returns. For example, investor requires returns of 7.0% for a property with a Net Operating Income (“NOI”) of $100,000, yields a $1,429,000 value. If the loan was underwritten when investor required yields were only 6.0% (a $1,667,000 property value), then the subsequent value decrease could jeopardize a lending institution’s collateral margin. In this example (which inherently assumes a short time frame in changes in investor expectations and/or flat rental income), an original Loan-To-Value (“LTV”) ratio of 75% would increase to 87% (in the absence of principal reductions).
As part of prudent underwriting and decision making for CRE lending, the appraisal review processes should analyze the reasonableness of appraisal inputs and assumptions. In regard to the income approach to value, applied rents should be well supported with respect to the current income of the property and any encumbrances/leases as well as income of other comparable properties in the market. Vacancy and collection rates, as well as appropriate capitalization rates, should be well-supported in the same manner.