The year 2008 will be remembered as a paradigm shift for valuing real estate. As the recession takes hold of the economy, we have seen lenders tightening their loan parameters, the pool of buyers reduced, and investors demanding a higher return on their equity.
Today, typical loan-to-value ratios are 60 to 65 percent, as opposed to 80 to 90 percent achieved in the last two years. Debt-coverage ratios have increased from 1.1 to as much as 1.65. Whereas many loans were being signed between 5 percent and 6 percent, interest rates have increased to 7 percent or even higher.
In addition, many lenders have decreased the amount of their amortization periods. During the height of the credit boom, it was likely for borrowers to secure interest-only periods as well as 30-year amortization schedules. Now, it’s difficult to achieve interest-only periods and amortization schedules are trending toward 25 years.
One of the major shifts has been the validity and the liquidity of the sponsor, the person who is receiving the loan dollars. Two years ago, most loans were non-recourse, accomplished without personal liability of the sponsor. Today, the reverse is true: The sponsor is usually personally responsible for the loan, the recourse. In addition to recourse, a lender might require a substantial down payment from the sponsor and also require a deposit be made with the lender to meet reserve requirements.
Many investors were able to enter the real estate market due to the low down-payment requirement and non-recourse loans. Factor in aggressive amortization and interest rates, and it’s easy to see the barriers to enter the real estate market were low; therefore, the demand for real estate skyrocketed. Since equity was plentiful, competition between buyers ensued. Many offerings had multiple letters of intent, leading buyers to curtail their return requirements to be the winning bidder.
As the lending environment changed in late 2007 and in 2008, many buyers had to sit on the sidelines because of the new levels of equity required to acquire real estate. As down payments of loans increased, buyers increased their equity position threefold.