Geoffrey Eng, Client Engagement Director
Mixed messages in news media about the state of the economy signal a market fraught with uncertainty, and if you’ve been keeping up, it seems that despite optimism from the Federal Reserve, the outlook (at least in the short term) may not be so good.
Analysts have made consecutive reductions in 2022 earnings forecasts over the recent weeks for several reasons, chief among them being weak demand, the Russia-Ukraine war, and interest rate hikes. The market has been soft since the end of last year, and the last month has been particularly brutal in equities, which historically precedes softness in real estate as well.
With a record number of U.S. office leases set to expire this year (243 million square feet, or 11% of overall leased office space) it seems that real estate has caught up to the current market conditions sooner than we might have expected. But there’s more to unpack here. The ongoing conversation around hybrid and remote work is impacting the demand for office in general. And coupled with rising interest rates and looming debt, it’s likely that this will ultimately impact property values.
It’s not all bad news with certain industries buying up large swaths of CRE, but it’s certainly concerning. What to do about it? Check in on the health of your portfolio.
Even if you completed annual loan reviews in Q1 of this year, you may want to take a second look and here’s why: if those reviews were completed using stale assumptions or stress parameters, your findings may not hold up based on where we’re at today. In other words, with renewed volatility and uncertainty in markets, it’s a good idea to perform an updated review of your portfolio so you can tag those that are already displaying weakness for continued monitoring moving forward.
What may seem like an inconvenience, could end up saving you pain and trouble later on. Proactive reviews will provide your organization the breathing room you need to strategize ahead of these newer and unforeseen issues. This means you can be less reactive if downside scenarios play out.
To that end, we wanted to share a sample checklist of metrics and underwriting scenarios that may be valuable for your loan health checks.
1. Update the property actuals.
This includes rent rolls and profit and loss statements. You’ll also want to check that the 1st installment of property taxes were paid on time.
2. Review nearby comparable data.
You’ll want to get an understanding what is happening with market rents. What does the velocity of market sales look like? What is happening with cap rates? How much inventory is currently out in the market, and what upcoming inventory might add to that? How is absorption trending?
3. Stress test and review additional scenarios related to:
- Debt Service Coverage Ratio (DSCR) – will rising rates prevent the borrower from meeting any payment covenants in place? Assuming a rising-rate environment, is permanent debt as an exit-strategy still a viable option? Was this a loan that was structured with an interest reserve? Is there enough reserve allocated to the loan based on projected future draws (or was this structured with a light interest reserve amount to help win the deal at close?)
- Terminal Value – as the loan reaches maturity, you’ll want to know if the value of the property will still be favorable. Will it be sufficient for a refinance / takeout lender? Sufficient to be sold with proceeds in excess of the loan amount? Is it in breach of any LTV covenants in place? Etc.
- Debt Yield – based on our fully funded loan amount, will rents/income being achieved by the property provide a sensible return in the event you have to take back the asset?
- Timeline – is the current maturity coming up within the next 6-12 months? Is the current exit strategy valid? Will an extension be necessary (and if so, do the docs currently have language to support this?) Are any third-party reports needed to facilitate this?
4. Check for covenant breach and review default remediation.
Are there any loans trending towards a breach of loan covenants that would require further remediation? Do you need to think about getting legal involved or getting your ‘ducks in a row’?
5. Review and update borrower/sponsor/guarantor information.
- Have you received updated tax returns and run updated spreads on cashflow?
- How does liquidity and net worth look if a capital call/infusion was required for the project?
- Do your borrower/sponsor/guarantor still have enough “skin in the game” to stick with the loan and see the project through if market conditions deteriorate?
Keeping these things in mind as you check in on your portfolio is a good way to determine the overall health of your loans and help you identify those that might be at risk. That said, doing so isn’t always a simple task and running health checks can eat up a lot of time. The good news is it doesn’t have to.
Blooma users have the ability to perform these types of portfolio monitoring exercises within the platform. In Blooma, you have the ability to run stress tests in each deal to identify areas of heightened risk by adjusting revenue, expenses, cap rate, and vacancy to analyze the affect they may have on the DSCR, Debt Yield and LTV of the loan.
In addition to the review of collateral valuations, Blooma also supports the analysis of Borrower / Sponsor / Guarantor financials. This includes the automated parsing and spreading of financial documents such as tax returns, personal financial statements, schedules of real estate, and liquidity statements. The system parses through those returns, and similar to what you would normally do with Excel or a tax spreading software, Blooma can spread those values into an understanding of what the individual’s cash flow looks like from a pro forma perspective. This analysis rolls up into a global view of the cash flow, or net worth or liquidity support for a deal.
Personally, what I find most helpful, is that the system keeps deal scores up to date based on real-time data so you can continuously monitor your deals without all the extra leg work. Just because we’re in uncertain market conditions doesn’t mean you need to be uncertain about your portfolio, too. Hopefully this checklist gives you a good baseline of what to review and update, and what you should look out for in the coming months.