Borrowers can now more easily observe that the higher the cap rate used, the lower the underwritten value. What the lenders are analyzing is how to capitalize the net operating income. After analyzing the income and expenses on a property and then arriving at a net operating income (NOI), lenders must then determine what type of return on the investment should that NOI be representative of. Riskier projects are typically subject to higher underwritten cap rates and vice versa. By using a higher underwritten cap rate or in other words a higher rate of return , lenders are thereby decreasing the value of the project in accordance with the type of return the lender feels an investor should be receiving given the risks and rewards of the project.
Lenders have very strict leverage constraints. Typically lenders, Commercial Properties, will lend a maximum of approximately 75%, and at times 80% of underwritten value. Therefore it should be clear that when lenders underwrite a loan using a higher cap rate, thereby decreasing the underwritten value of the asset, that the maximum loan amount offered will likely be reduced. Although, Commercial Properties approach the valuation analysis using the same basic methodology, the Income Capitalization Approach, it is important for Borrowers to understand that the underwriting cap rate may be substantially different than the market cap rate (the cap rate properties are currently trading hands at in the market). This can be a difficult concept for some Borrowers to get their arms around but it is the foundation to understanding how there can be such a big disparity in maximum loan proceeds offered by Commercial Properties. In the current commercial real estate market where cap rates remain at forty-year lows, lenders find themselves in the precarious position of addressing the sometimes vast disconnect between low cap rates and weak real estate fundamentals.
When striving to reach the full loan dollars sought by borrowers, lenders are conflicted with the idea of using market cap rates or artificial cap rates. Market cap rates are cap rates that can be supported using data from other transactions currently taking place or recently achieved in the marketplace. Note however, that just because a certain cap rate is achieved in today’s market that that is not necessarily an indication of the cap rates to be achieved in the marketplace at various points throughout the loan term. If you recall from the discussion above that compares the two types of Income Capitalization Approach, the Direct Approach, which is the most commonly used of the two, only kicks out a single NOI figure. Therefore, unlike the Indirect Approach, which can account for specific, future annual adjustments in the NOI analysis, the single NOI derived using the Direct Approach must be representative of the average of what is expected to take place over the life of the loan term. And therefore the cap rate applied to the NOI in the Direct Approach must also take on that same philosophy. That should through the real estate loans. Therefore, in order to sell (securitize) the loans successfully there has to be sufficient evidence that the loans can support the coupon payments promised to the bond investors.
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