Debt Service Ability
Debt Service Ability. A renewed lender focus it seems. As referenced in our recent post entitled Interest Rates and Property Values. What’s the Connection?; we laid out the relationship between Interest Rate increases and property values. As interest rates firm, valuations are impacted, and cap rates begin to firm. What about Debt Service Ability? It is becoming more apparent that property income, and more specifically net operating income available to service debt, has a significant and growing influence on the amount of debt available to a commercial property owner. This is increasingly evident with lender attitudes as well. Cash is King to your commercial lender, notwithstanding the relative amount of leverage on your asset.
What’s the Norm?
Loan amounts equivalent to 75% of property value or purchase price, while perhaps never the “norm” were certainly prevalent, and not at all unusual. It would appear that institutional lenders are signifying their reluctance to “reach” for loans. They are now more frequently capping their maximum exposure to 65% to 70% of property value or purchase price. The ability of the property to comfortably service the debt is of paramount importance.
Why the shifting focus?
Are there other factors at play here? Yes, Canadian lenders regulated by the Office of the Superintendent of Financial Institutions are mandated to stress test their loans to individuals for personal mortgages. While not directly impacting commercial mortgage underwriting, institutional lenders, particularly those regulated federally, are working within a regime of increased oversight. There is a focus on both the quantum of, and absolute rates associated with consumer debt. It is perhaps no surprise that commercial lending is undergoing more focused attention as well.
Commercial lenders are also employing stress testing as an underwriting “best practice”. This stress testing can take many forms, ranging from determining the “break even” interest rate at time of loan approval (the increased rate levels which will still yield positive debt service coverage), to forecasting debt service coverage at loan maturity, at a rate higher than the contractual interest rate.
More generally, we have been operating in an extended period of low rates. Low single digit 5 year commercial mortgage rates have been with us for such a lengthy period now, that LTV considerations were often not of a significant concern from a loan underwriting perspective. This is now changing, with a renewed focus on the sufficiency of property cash flow.
What are the implications?
Mortgage lenders will be increasingly focused on debt service coverage in their underwriting processes. Borrowers should be aware that increased equity, or secondary debt may be required to secure real estate assets. The focus for income property owners has to be on maximizing Net Operating Income.
Understanding your property’s income generating capabilities, and maximizing every opportunity to grow and stabilize cash flow, will be your key to financing success in today’s increased interest rate environment.