Friday Letter Yielding to debt

As real estate investors go back to cash flow fundamentals, lenders are going one step further in underwriting loans by reviving the debt yield test. 

Private equity real estate players have gone back to basics across the globe when it comes to searching out the best opportunities.

Deals are no longer underwritten with cap rate compression or rent growth assumptions in mind. Rather, transactions have to be steeped in the cold, hard realities of property markets today.

For people like Richard Mack, AREA Property Partner’s North America chief executive officer, this means “buying cash flow”, as he said during this week’s Michael Stoler summit. Such a retreat to safer, income-producing properties reflects the uncertainty still inherent in real estate markets globally.

Few are willing to make large bets today on what might come to fruition in the future, particularly when true values are almost impossible to pin down. But cash flow is tangible in this environment, and Mack’s strategy was reiterated again and again by a majority of the investment professionals at the New York conference.

Yet despite this move by investment professionals back to cash flow fundamentals, for lenders it hasn’t gone far enough. Instead, lenders themselves are starting to use another “back to basics” tool to assess the viability of loans: the debt-yield test.

Stung by lax underwriting standards during the property boom years, most banks and lending institutions have severely tightened lending criteria over the past years, introducing much lower loan-to-values and higher debt service coverage ratios while reserving most of their real estate capital for existing relationships.

But for those that are able to deploy fresh cash into the marketplace, debt yields have become an important means for underwriting deals. Debt yields measure net operating income as a percentage of the loan amount, and are viewed as the most direct method for calculating risk. The higher the debt yield, the more attractive the mortgage is to the lender.

Over the past few years debt yields were deemed almost irrelevant, as investors and lenders forgot about risk and gorged on a buffet of easy credit. With risk now back to being front and centre in the minds of all lenders, debt yields are once again the favoured benchmark.
As a result, institutions able and willing to lend are often setting minimum debt-yield levels, with many looking for at least 11 percent to 12 percent or even higher.

However, even the best debt yields can’t guarantee you a loan. Vornado Realty Trust highlighted its frustrations at the conference in securing a $400 million loan for an office building, despite a debt of 15 percent. The size of the loan has proved challenging for the REIT, with Stoler himself remarking: “Trying to pull some [financing] deals together is like herding cats.”