The federal and bank regulatory agencies in June proposed loan-to-value ratios on real estate loans. The Mortgage Bankers Association, in a comment letter to the four regulators, urged they they be more flexible and not apply at all to one- to four-family residential loans that meet secondary market underwriting standards. Here are excerpts from the MBA comments on the application of LTV ratios to commercial real estate loans.
Funds available to finance commercial real estate continue to remain scarce. This credit shortage extends far beyond new construction to encompass existing loan refinances, funds needed for tenant improvements to retrofit re-leased space and monies required to provide capital improvements for property rehabilitation. A 1991 survey of life insurance companies, the typical providers of permanent commercial real estate loans, demonstrates the lowest volume of new commercial real estate loan commitments since 1982, when interest rates averaged 14%. This $6.3 billion in new commitments authorized represents a 55% decrease over 1990.
Life insurance companies have historically served as the permanent lender that "takes out" the construction lender, e.g., the commercial bank, upon completion and leasing of the property. With life insurance companies' retrenchment from the commercial real estate market, borrowers have faced significant difficulties in paying off their construction loans. In addition, despite efforts to expand the secondary market for commercial real estate, almost 90% of the estimated $5 billion in non-agency commercial mortgage securities issued in 1991, was issued by the Resolution Trust Corporation, or by entities that purchased collateral from the RTC. This dollar volume pales in comparison to activity in the residential secondary mortgage market. Thus, the limited commercial real estate secondary market has not furnished the requisite liquidity to revitalize the industry.
In commenting on the proposed uniform real estate underwriting standards from a commercial real estate perspective, MBA wants to underscore real estate's historical role in revitalizing the U.S. economy by stimulating employment. The lack of funds for construction and rehabilitation results in foregone capital improvements to industrial properties, apartments, shopping centers and office buildings, resulting in neighborhood deterioration, declines in tax bases and eventually, a corresponding reduction in services provided to our citizenry. With this underlying perspective, we provide below our remarks pertaining to the LTV ratios, the exemption for existing loans, the pre-leasing requirements, the amortization qualifications and the non-conforming loan allowance prescribed in the proposed rule, emphasizing flexibility in establishing bank lending policy.
Because commercial real estate mortgage quality stems from a variety of interrelated factors, it is not uncommon for equally qualified underwriters to perceive mortgage attributes in a very different fashion. For example, one underwriter may regard owner occupancy of an office building as a strength because it demonstrates a commitment to the property. However, another underwriter may consider owner occupancy an added risk, particularly in the event of default or bankruptcy, whereby the lender would not only experience a loan default, but would also lose the sole tenant. Flexibility in evaluating loan characteristics reflects the business nature of commercial real estate--its fluctuations in relationship to business cycles and its dependence on local market conditions. Given the reliance on local market knowledge in effecting sound investments, MBA strongly emphasizes the importance of regulatory flexibility coupled with prudent implementation when assessing a bank's mortgage quality.
To stem further liquidity constraints and depressed real estate values, MBA opposed more stringent LTV restrictions than those established in the pre-1982 law. Moreover, LTVs represent only one of many factors considered when analyzing commercial real estate loans.
In accordance with sound appraisal practices, an underwriter considers three approaches to real property valuation: (1) sales comparison; (2) physical cost: and (3) income capitalization. This three-pronged approach enables the appraiser to implement a check and balance procedure in arriving at a final value estimate. Because the value generated from commercial properties stems from the rental income paid by lessees and the residual land value at the end of the prescribed holding period, appraisers/underwriters have typically stressed the income capitalization approach when valuing commercial real estate. The income method involves: (1) the present value of future benefits of property ownership; (2) resale and reversion cash flows; and (3) before and after tax cash flows.
In estimating value, heavy reliance on the residual value of real estate can grossly distort the property's ability to generate cash flow in the short term and consequently, to service the mortgage debt. Thus, in highlighting LTV ratios as the primary quantitative factor in assessing a commercial real estate mortgage's soundness, the federal banking agencies have overlooked the single most significant determinant--debt service coverage. Debt coverage is of paramount importance, particularly in today's market, where the lack of arms-length market sales often reduces the ability to reconcile the sales comparison and the income valuation methods.
Exemption for Existing Loans
MBA supports the federal agencies' exemption for loans renewed, refinanced or restructured by the original lender(s) to the same borrower(s). As mentioned, there is an abundance of maturing loans over the next several years. Further refinance restrictions would place an undue burden on already distressed borrowers. Under the proposed regulation, the lender(s) could not advance new funds without voiding the exemption. MBA believes in certain cases where the lending institution renews a loan in an amount exceeding the outstanding principal balance to further protect their interest in the property, the lender should retain the LTV exemption. For example, if a creditworthy tenant agrees to lease vacant space at market rents contingent upon tenant improvement construction (the costs of which would be amortized over the lease term), the federal banking agencies should permit the necessary advances, without eliminating the exemption. In this way, the rule would allow the lender to extend credit that would enhance the property's value.
The real estate under writing standards recommended by the federal banking agencies permit a 75% LTV ratio for construction and land development loans if they involve "a project that is at least 65% pre-leased to a tenant(s) with sufficient financial capacity to fulfill all material obligations under the lease ... ." Percentage occupancy requirements address the degree of physical space leased; however, these mandates overtook the income actually generated from leasing this physical space. For example, a building may be 65% leased to a credit tenant. However, because the tenant will occupy such a significant portion of the space, the landlord may have granted considerable concessions. Let's assume the tenant has signed a five-year lease, for $35 per square foot for 100,000 square feet, with 16 months free rent and above building standard costs estimated at $40 per square foot. These concessions yield an effective rent of approximately $1.400, based on a 10% discount rate. Therefore, although the space is 65% leased, these occupancy percentages do not necessarily reflect the same percentage of total income produced. Thus, given the ability of cash flow to more accurately measure the capacity to meet debt payments, MBA believes pre-leasing determinations should be incorporated into an individual bank's loan policy, instead of subjecting borrowers to more stringent LTV requirements based on a physical occupancy criterion.
The proposed rule applies different LTV ratios for improved properties based on amortization. Specifically, the suggested regulation permits a 75% LTV ratio for improved property loans that "amortize over the life of the loan." The proposed rule also would limit the LTV ratio for an improved property loan that does not amortize over the mortgage term to 65%. MBA requests clarification regarding which loan structures would constitute an "amortized" loan over the loan term. Clearly, self-amortizing loans would qualify. However, most commercial real estate loans issued on improved properties include a "balloon" payment, comprising a large percentage of the original principal. These "bullet loans" do "amortize" over their life, in that a portion of the principal is amortized prior to maturity. The balloon payment, paid with the final interest payment, would represent the total outstanding principal at maturity. Requiring "full" amortization over the life of a bank loan without a balloon payment conflicts with typical market practice. Furthermore. such a mandate would defy the essence of a bank's short-term lending nature. Therefore, MBA strongly opposes any requirement for self-amortization over the loan term to meet the 75% LTV ratio proposed for improved property loans.
Non-Conforming Loan Allowance
MBA supports the allowance for non-conforming loans. Such a vehicle will permit banks to originate loans that exceed the LTV limits but conform with prudent lending guidelines. For example, a triple-A-rated tenant may pursue a build-to-suit in a well-leased office market to relocate its corporate headquarters. The borrower may agree to develop and construct such offices. Let's assume this triple-A-rated lessee signs a long-term lease and the borrower has an excellent payment history on other loans with the bank. This mortgage exceeds the LTV ratio recommended in the proposed rule; however, the loan could actually represent a higher quality, more reliable investment than other loans meeting the LTV standards. In such a way, the agencies have crafted an appropriate means for extending credit on high caliber non-conforming loans. However, the 15% capital constraint. put forth in the proposed regulation, does not furnish adequate flexibility. Comments from members suggest a level of approximately 25% would be more reasonable. However, should the banking regulatory agencies agree to allow for LTV ratios at the higher end of the published range and provide flexibility on amortization and pre-leasing/pre-sale requirements, this 15% ceiling may prove more workable.