Underwriting Commercial Real Estate in the Era of COVID-19

Posted by Charlie Dunlap on May 6, 2020 2:12:30 PM
Charlie Dunlap

wall street covidThe COVID-19 crisis has brought significant stress to the commercial real estate financing market resulting not only from the obvious effects of putting the U.S. economy on hold, but also because commercial real estate and social distancing don’t mix.

The inevitable result will be missed rent, forbearance, and potential defaults by tenants. Landlords will need to accept this and work with tenants or risk sending tenants into bankruptcy. This will create unoccupied spaces in their buildings and destroy relationships with otherwise good tenants.

When crises hit, the biggest challenge in underwriting commercial real estate is in sorting out which issues are brief interruptions, and which will have long-term impacts on value (i.e.  understanding the difference between a suspension of the rules and a changing of the rules). For example:


  • What is the certainty of cash flow? In the immediate aftermath of an economic shock, it’s impossible to know how stable existing rents and occupancy will be.
  • Hotels were hit the soonest and hardest, with national occupancies now averaging at 6% nationwide and downtown core areas as low as 5.9% according to STR. They can’t be underwritten in this climate. History suggests that occupancy rates will recover, however, the nature of this crisis suggests that it may take far longer to recover and that the eventual stabilized rates might be significantly lower than in the past.
  • Currently, retail is difficult to underwrite unless its grocery, pharmacy, or other essential sectors.
  • In the retail sector, there has been a wide variety of tenant responses. Tenants' willingness and ability to pay is not currently predictable based on simple metrics like size and credit quality. In many cases, once the doors reopen, business could return to pre-shutdown levels.
  • Unfortunately, one of the strongest sectors of retail during the post-financial crisis recovery--the restaurant, entertainment, and exercise sectors--may be the hardest hit due to potential lingering health concerns about the ongoing need for social distancing.
  • With office buildings, there has already been speculation about the impact on demand for space due to the success that many businesses are having with the work from home experience. While there will likely be less of a stigma associated with working from home overall, abandoning the central office concept seems like a bridge too far for most businesses. But what about concerns that employees may have when being placed in the ever-decreasing footprint of their workspaces putting them into closer proximity to co-workers? Could this event trigger a reversal of that trend and, on net, increase demand for office space?
  • How much of the recent increase in shopping online will be permanent? What is the long-term impact on warehouse and industrial space needs and the location of those spaces?
  • How do we factor in lower yields and values? How much upward pressure will there be in cap rates and how quickly and for how long will values compress?
  • What “work-around” can we do to inspect the property during underwriting? Drones and virtual walk-throughs have the potential to become long-term permanent solutions.

Even with these difficulties, capital providers with dedicated funds, continue to operate but with changes to their underwriting such as:

Increased interest reserves - New multifamily loans normally required an interest reserve of at least 6 months, but now it is more likely to be 12 to 18 months.

Increased vacancy factor - Lenders are very focused on underwriting to actual vacancy rather than a market vacancy factor.

Elimination of cash-out funding - The elimination of cash-out financing, which has reduced the leverage on loans.

Reducing non-recourse - Loans that could previously be approved for non-recourse are now requiring various recourse provisions, such as for the first 2 years, or the top 50%, or some form of “burn off” recourse.

In this climate, we expect that we will see slower loan closings because of the lack of clarity of the unique impacts that this event will have on the drivers of real estate values. There will be de-leveraging and more properties being valued based on their replacement cost. Generally, vacant building deals will not get done. And we expect to see lenders re-trading their previous quotes, looking for higher yield, and increasing the period required for interest and tax reserves.

Other lenders are still looking for deals:

  • There is very little bridge lending happening; no one knows what leasing velocity is going to look like. Many bridge lenders are on the sidelines because they rely on bank funding. And those banks are concerned about underlying asset values and performance. Please note that RRA Capital is not one of them and still participating in bridge lending.
  • While some regulated banks are taking a 60-day pause, in general, local and regional banks are still lending, with high reserves and personal guarantees (55%-65% LTV’s with rates of 4.5% to 5.5%). Banks are expecting the borrower to bring accounts and business. A regulated bank could do an 8%- 10% interest bridge facility, with a low LTV and guarantee.
  • Some life companies are still actively quoting new transactions, managing deal flow by widening spreads, and establishing floors. They have money to lend at interest rates of 4.5%-5% at LTV’s of 50%- 55%. Insurance companies had backed away from direct lending. They could buy AAA CMBS at over 300bp, but now with TALF bringing those spreads back to around 160bp, CMBS is not cheap enough and they are rotating back to loans. Pre-COVID coupons were at 3% and now are above 4%.
  • Some CMBS lenders are placing deals under application but are not finalizing pricing as both lenders and the market as a whole await more pricing discovery. However, the CMBS market will reactivate. The Fed will be buying this paper (The Federal Reserve's $2.3 trillion loan stimulus includes plans for outstanding commercial mortgage-backed securities and newly issued collateralized loan obligations).
  • Agencies are still underwriting, requiring much higher reserves. They are wanting 12 months reserve to include taxes and interest. Fannie and Freddie are actively lending with spread rates of 5%-4% of interest reserves, and tightened up DCR of 1.35.
    • Fannie Mae - spreads flattened earlier this week, falling significantly from when BlackRock, on behalf of the Federal Reserve, began purchasing DUS bonds. Meanwhile, Fannie has instituted new credit guidelines that establish a reserve for debt service, taxes, and insurance for 6 to 18 months, depending on the loan size and loan-to-value ratio. As of April 3, 2020, current Fannie Floors are 0.80% for a seven-year term; 0.70% for a five-year; 0.90% for a 10-year; and 1.30% for a 30-year.
    • Freddie Mac - is starting to institute new credit policies that will require principle and interest reserves in addition to tax and insurance reserves. As of April 3, 2020 Freddie, is quoting the greater of the spot rate minus 15 bps or 75 basis points, as index volatility continues.
  • Private money, unlevered funds, that are in business favor apartments, industrial, and office. Big funds will be buying distressed deals. Expectations for volume of distressed loan sales revolve around what collections will be like. The feeling is that banks can handle 20-30% non-payment but if that rises to 50%, they will need to offload loans.  We’ll need for 3-6 months to pass before we see how this shakes out--and lenders will be financing those.

Our conclusion is that even after the economy has reopened there will be some “marking to market” of valuations. This may create issues for appraisers and RRA Capital as we work to determine “value” on the other side of this crisis. So, lender underwriting must remain exceptionally diligent even past the end of the COVID-19 pandemic.

*Sources: George Smith Partners, HFF, CBRE. Marcus & Millichap, NAIOP, National Multifamily News, National Real Estate Investor and Wall Street Journal.

Topics: Market Update

Charlie Dunlap
Written by Charlie Dunlap

Charlie Dunlap, a former partner of Trammell Crow, is the Founder and Chairman of RRA Companies. His more than 50 years of experience in the industry has involved the development, construction, rehabilitation, and management of assets valued at more than $2 billion. He has developed, built, or rehabilitated more than 10,000 housing units, managed over 11,000 apartment units, and managed or developed industrial, office, and retail properties in excess of half a million square feet. Mr. Dunlap has been named the Arizona Certified Property Manager of the Year and was presented with the Phi Epsilon Professional Award from Arizona State University.