BANKERS OFTEN ASK a lot of questions before agreeing to fund a commercial real estate project — and that has always been the case. However, asking the right questions, and understanding the answers, can lead to a successful project for all involved.
Since the most recent downturn, deals have tended to include much more equity in them than they did in the previous cycle because the industry has remained disciplined regarding leverage. Many projects financed today have at most 65 percent leverage, and in many cases less. Prior to the last recession, leverage in the 70- to 80-percent range was the norm.
Banks have also become much more attuned to the impact of a loan on bank capital and whether the deal provides a sufficient return. Compared to a decade ago, there is much greater sophistication in modeling expected losses, capital impacts and return on capital.
Many large banks have also gravitated toward projects in first-tier, heavily populated cities due to the tenant demand and liquidity available in those markets. This has impacted the capital available for projects in secondary and tertiary markets.
Here are five key factors that go into a commercial real estate funding decision and the main questions bankers ask when considering a loan:
1. Sponsorship. Do the sponsors have a strong track record through economic cycles? Do they have experience in the property type and geographic market? How much do they have invested in the project, i.e., “skin in the game”? How deep are their pockets, and do they have the capacity to provide more capital if needed? What prior experience does the bank have with them, and how have they behaved previously when a project encountered issues? What is the sponsor’s plan — and does it make sense?
2. Macro Strength of the Market. What are the general economic conditions in the region? How is growth in jobs and population? Is there demand for the product (office space, apartments, hotel rooms, etc.) and what is driving this demand? Who are the large employers, and what industries are driving the local economy — what does the future look like for these companies/industries? Why are people moving there or moving out? Is it an attractive region for institutional capital?
3. Micro Market Conditions. What are the supply-and-demand factors for the property submarket? What are the absorption rates of new space and units? What new supply is in the pipeline and how will this affect the project? Are rents increasing, decreasing or flat? Is vacancy rising or falling? How will the project compete against other properties? Why would a prospective tenant choose this project over competing buildings? Are rent and vacancy assumptions reasonable compared to the rest of the market? What is the history of the project or building? Is the lender financing competing projects?
4. Structure. How leveraged is the project and how much equity (cash) does the sponsor have in the deal? What are the loan-to-value and loan-to-cost ratios? Is there sufficient cushion? What does debt service coverage look like? Is there sufficient cushion for that? Are there performance-based covenants to safeguard that the project stays on track? (These covenants can include debt service coverage or debt yield ratios, leasing progress, completion milestones and restrictions on distributions.) What is the term? Has space been pre-leased? Who are the tenants? Are they credit-worthy? What are the lease terms and rollover risk? Does the sponsor guarantee the loan, and to what extent? Do the guarantors have the financial ability to solve a problem should one arise? How much other debt do the sponsors guarantee? Is there construction risk? How is that mitigated? Are the sponsor and contractor experienced? What is the pricing and what are the fees — is the lender being adequately compensated for the risk?
5. Strategic Fit and Risk Appetite. Are the sponsor and location consistent with the bank’s CRE strategy? Does the project fit the bank’s plan for property and geographic diversification? Is it in a target market for the bank? Is the risk consistent with credit policies and risk appetite?
That’s a long list of questions, but most are the same ones a developer or owner will be asking as well. A strategic banking partner that helps make sure a project is checking all the right boxes can serve as a trusted adviser that helps a client reach its potential.
Gary Magnuson is the head of commercial real estate finance for Citizens Bank.