Rethinking the way loans will be underwritten in a post-COVID environment
The effects of the coronavirus on the other three Cs (collateral, cash flow and credit) have been swift and, in many cases, painful. This pandemic has caused a “reset” in the minds of many Canadian lenders and will inevitably usher in some rethinking of loosening underwriting standards we’ve seen over the last decade.
As with any massive paradigm shift, predicting the new normal is challenging and leads many market participants to pause. For many in the commercial-lending community, their current reality is managing a multifaceted business while maintaining liquidity, managing the credit risk of their existing book, and figuring out how to operate prudently going forward.
How could underwriting change?
At Canada ICI, we are observing a pullback in the marketplace as many groups work to adjust to the rapidly changing landscape. This hesitation has led to significant near-term changes in underwriting parameters. We believe these changes will persist until there is a clearer picture of when the crisis will end, the economy will reopen, and finally, what the fallout will be.
In the meantime, there are some downstream changes in underwriting that could happen:
Lower leverage ratios
It will be challenging to pin down asset valuations as it won’t be easy to ascertain future revenues, vacancies and cap rates. Until there is clarity on valuations, we expect to see lenders compensate by reducing their maximum loan to value ratios.
Bifurcation of values within asset classes
For the better part of the last 15 years, the risk premium between Class As and Class Bs has been relatively thin. At Canada ICI, we believe that the lending market becomes hypersensitive to understanding the resiliency of an asset’s tenant base. More resilient and defensive assets will be rewarded with pricing. Pay specific attention to collection ratios (contracted rents vs. actual collections) over the next 120 days and how they differ by asset classes and markets.
“Show me the liquidity” if you want a construction loan
Land and construction financing will be challenging in the near term resulting in more significant equity requirements with more focus on sponsor liquidity and track record. Exit underwriting needs to settle on revenue and expenses in a post-COVID world.
Naughty and nice lists
The Canadian lending market is a relatively small community. A borrower’s conduct on existing loans throughout the recent pandemic will be seared into the minds of lenders for years to come. The borrowers who have been proactive and transparent in communicating actual collections and working with their lenders will build significant goodwill and this will pay future dividends. Whether a borrower previously sought relief or sought a deferral during the pandemic, this will form part of many lenders’ credit adjudication process on future loans.
A focus on CMHC products
Canada Mortgage and Housing Corporation (CMHC) has been and will continue to be one of the most reliable vehicles to access multi-family asset capital. Look for lenders across Canada to increase their exposure to CMHC financing.
More structure on conventional products
Traditional balance sheet lenders may look to add more Commercial Mortgage-Backed Securities (CMBS) style features on their loans (i.e. cash-flow sweeps, leasing reserves, earn-outs, cross-collateralization, springing recourse, etc.) to further decrease risk to their loan positions.
Going forward, we expect that the current experiences of lenders will strongly influence post-COVID decisions.
The longer the crisis, the greater changes we’ll see
It is difficult to foresee all aspects of potential changes in underwriting criteria. The longer the shutdown persists, the more significant the impact on the economy and, consequently, existing loans. The longer this plays out, the more drastic the future changes will be. The good news is that efforts across the country to “flatten the curve” seem to be working and hopefully will translate into a more stable economic environment sooner than later.
Part 1 of this series shares Canadian ICI experts’ perspectives on how they think the pandemic will impact Canada’s economy and affect future CRE lending.
As the pandemic continues, some of the perspectives in this post may fall out of date. This blog post reflects the views of experts at Canada ICI as of April 30, 2020.
Content and strategies shared on NAIOP blog posts are intended to provide information and insights to industry practitioners and do not constitute advice or recommendations. NAIOP and its blog authors disclaim any liability for actions taken as a result of these blog posts.
Visit the NAIOP Response: COVID-19 page for critical resources and knowledge to support you now.
Yvan Repka is the Managing Director of the Canada ICI’s Ottawa office and has worked in finance for the last 20 years. Yvan has worked as a commercial lender for one of the Big Five banks and has had exposure to the capital markets while working for the Calgary-based subsidiary of one of the world’s largest asset management firms. As a broker, Yvan has coordinated over $1.5 billion of construction, bridge, and term financing for clients ranging from large institutional borrowers to private entrepreneurs.