There are an endless number of commercial real estate (CRE) lenders and they all seem to have slightly different criteria that must be met for a loan to be approved. For example, a lender in New York may have a minimum liquidity requirement that must be met to receive the most favorable multifamily loan pricing while another lender in San Francisco or Chicago may have no such requirement. On the surface, this wide range of qualification criteria doesn’t make sense, but a closer look reveals that they can be driven by an unlikely source, commercial capital markets.
Credit Policy vs. Capital Markets
In almost all cases, loan approval requirements originate from one of two places, a lender’s credit policy or the secondary market purchase criteria established by large real estate investors. Details on each are below.
Fundamentally, the business model for commercial real estate lenders is a simple one. They borrow money from one place at a given interest rate and they lend it out to someone else at a higher rate and they keep the difference. The most classic example of this is a retail bank who “borrows” money from individuals who open checking and savings accounts at very low interest rates (e.g. .50%) and then use this money to fund real estate loans at higher interest rates (e.g. 5.00%). The difference between the two rates is known as the interest rate “spread” and it represents the lender’s profit on the transaction. To minimize the risk of not being able to “repay” the individuals from which the money was borrowed, the lender has to be very careful about the risk associated with the loans that they make. So, it is in the best interest of all parties for each lender to establish a very clear set of approval criteria for each loan type.
Nearly every lender has a “Credit Policy” that outlines their loan approval requirements for each different type of loan on commercial property, based on the perceived risk associated with it. For example, a multifamily loan in primary markets like Atlanta or Los Angeles could have vastly different approval criteria than a hotel loan in a tertiary market outside of Nashville or Dallas. The elements of the approval criteria outline key risk metrics like Loan to Value (LTV), Debt Service Coverage Ratio, location, property type, and asset class. Depending on the lender’s risk appetite for each, they will set a minimum value that must be met for the loan to be approved. So, when they evaluate a loan request that has an LTV of 85%, but their credit policy states that the maximum allowable value is 80%, they may be less likely to approve the loan.
But, what drives the metric requirements outlined in the Credit Policy? For primary lenders who originate and service their own loans, the metrics are driven by their own expertise and experience about what makes a commercial mortgage loan “safe.” However, there is a completely separate world of investors like REITs, hedge funds, and government agencies who like to purchase loans once originated and securitize them for sale to other investors. The market created by these activities is the “secondary market” and in this market, loan approval criteria is driven by what investors are and aren’t willing to buy.
How the Securitization Process Works
The details of the commercial loan securitization process can be incredibly complicated, but the fundamental concept is relatively simple. A lender will make a significant number of loans and then “pool” them together, package them into a financial product, and then sell them to individual or institutional investors. These “Commercial Mortgage Backed Securities” are a common commercial real estate investment that offers investors exposure to the commercial real estate market without actually owning any physical real estate. As a holder of the loan security, the investor is entitled to a stream of loan payments on which they earn interest.
Where the securitization process can get complicated is that investors have a wide variety of return requirements, preferred property types (e.g. office buildings vs. industrial spaces), preferred metro areas (e.g. Orlando, Houston, Austin, or Phoenix), and preferred credit quality. To this end, investor demand can be a major factor in how a lender manages their loan approval requirements because they only want to originate what an investor is willing to purchase.
To illustrate how this works, an example is helpful. Assume that a major investment bank is an originator of multifamily loans. On one side, they have an origination desk with a large number of industry contacts capable of churning through a pipeline of multifamily loan originations. On the other side, they have a large number of clients chasing investment opportunities and the stable stream of payments that these loans offer. Because they have long standing relationships with the clients, the bank knows what their return criteria are and how much of a portfolio allocation they are willing to provide. So, they get a feel for these requirements and use them to drive loan approval criteria.
When enough loans have been originated, they are pooled together or “securitized” and these securities are sold to the investors who demand them. As the facilitator of the transaction, the investment bank stands to earn healthy fee income. In this investment market, investor demand for risk is constantly changing so their purchase requirements are constantly changing. For example, the COVID pandemic has caused a significant decline in demand for certain types of retail space (e.g. bars and restaurants) and a surge in demand for industrial space. In response, an investor is less likely to purchase a security backed by properties with a large number of bars and restaurants and more likely to purchase a security backed by warehouse space. In response, originators have adjusted their approval criteria accordingly.
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