By Jim Costello on September 2nd, 2016
At the Shanghai Advanced Institute of Finance conference in Beijing this week, Federal Reserve Presidents Eric Rosengren and Charles Evans discussed the Fed’s interest rate policy. President Rosengren delivered a presentation using a number of charts from Real Capital Analytics highlighting the risks lenders face now that commercial property prices are at or near cyclic highs. Lenders and regulators need to be concerned about high prices, especially as it impacts activity on the fringe of the market, but on average lenders are safer today than in the past.
The fear in the lending world of course is that with prices at record highs, some outside shock might impact property income and ultimately pricing. When prices were at their last cyclic highs, in 2007, aggressive lending was a big part of the equation. For loans against commercial properties, the average DSCR was only 1.3 into the peak of market pricing.
An average DSCR that low implies that there were some lenders well below that level with investors borrowing excessively to make deals work at the high prices. Even the average was bad enough. A 30% decline in cash flow would leave an investor with only enough cash flow to pay the loan and with more of an incentive to walk away from the investment altogether.
In the current market however, the average DSCR comes in closer to 1.7. There is simply much more cushion in the average loan originated in the current market. Should property income fall, it would need to fall more severely than it did in the last market downturn to incentivize investors to default.
Average DSCR levels are so different between these periods in part due to the way lenders are looking at property income. In ’06-’07 loans against pro forma income were common. Today, the average loan looks more to current income.
Averages are tricky though. The market may be OK overall but there are extremes in any market. If the extremes involve particular groups of lenders that could be a problem for the market overall. In the current yield-starved market, some lenders are going to be more incentivized to take on risks to generate returns.