By: Adam Horowitz
Lever Capital Partners is speaking with lenders and investors on a daily basis and have been hearing that changes in underwriting are at the forefront of their minds. The number one question capital providers are asking is, “In the current post-Covid world, what changes have you made in your underwriting assumptions?”. The conversation is a non-starter if the sponsor has not thoroughly thought through these changes and can’t clearly point to adjustments made in the proforma with a compelling story to back it up. Here are a few of the major underwriting changes we’re requesting from our sponsors (for now) and our recommendations about how to present them to the market:
- Cap Rates – Needless to say there is pricing uncertainty in the market (investment sales volume has dropped roughly 70% in Q2 2020 from the same period in 2019, according to CoStar and RCA Data). Pre-Covid comps are being ignored so it’s important to factor in a conservative premium to appease investors. Recently, we’ve seen value adjustments of 10%+ for multifamily properties up to 30%+ for hospitality, depending on the specific asset. Don’t be shocked when looking at your updated IRRs.
- Rent Growth – Underwriting future income streams poses a considerable challenge for most properties without long term leases or credit tenants in-place. Across the board, investors are underwriting untrended rents and factoring in zero rent growth for the next 2-3 years. In rare instances, some markets are projected to have a negative rent growth rate over the next 1-2 years. Where you build / purchase will be heavily scrutinized now.
- Exit Cap to Yield on Cost – In regular times we’d typically look for untrended yield on cost spreads of 150 basis points compared to the exit cap rate. The industrial and core multifamily spreads are holding close to those numbers but we’re seeing a much wider spread for all other asset classes. Be prepared to show numbers in the 175-200+ range.
- Spec Development – Building spec has always been a challenge, even in the most bullish of times. Office and retail have required a fair amount of pre-leasing even in the early part of this year. But now, given the circumstances, nothing is going to happen unless you are heavily pre-leased with credit tenants in tow. Walking into the lender’s office with a mask and a dream won’t cut it, so start lining up those credit tenants.
- Debt Assumptions – The lending world has dried up considerably with some participants leaving the market (debt funds) and others on the sidelines only willing to lend to existing relationships (banks). Overall, leverage has decreased with developments maxing out at 65% and more commonly in the 50-60% range while interest rates spreads have widened, increasing all-in rates. You’re likely going to need more cash, and investors are much more focused on the debt status than ever before.
Without these adjustments, most lenders / investors will take a quick pass. Your ability to identify and edit your original underwriting shows you’re adapting to the new normal, have an understanding of what metrics had to change and are able to craft a workable solution around the modified numbers. To come off as a sharp sponsor and on top of the market, we recommend having your changes ready to present by (1) preparing a doc that outlines your changes that you can share with investors and lenders and (2) crafting a compelling story for the asset and market that you can talk through.
These are the first things we ask for when looking at new deal packages. If you follow the above rules you might be one of the fortunate few to get a new loan or investor equity. We can help when you’re ready to “turn and face the strange” as Bowie said. We’re home working in our PJs waiting for you to call.