Real estate is never static. It changes regularly, constantly requiring all involved to keep current with the market. With so many facets to the real estate market, a participant must consider the perspective of the static industry professionals. These experts can include the realtors, vendors, buyers, lenders, appraisers and engineers, to name a few.
As a lender, one of the biggest challenges I face in this market is why the lending value and market value for the property can differ.
Market value can be defined as:
“The most probable price which a property should bring in a competitive and open market as of the specified date under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.”
Consider this: Everyone has their own definition or perspective of market value. Every buyer, or vendor, or realtor or lender interprets a different market value. Participants all have different assumptions they use when reviewing an investment property.
Challenge in completing financing
The divergent views can lead to one of the big challenges in completing financing i.e. reconciling why the lending value is different than the market value.
In a very active market, a major contributor to the difference arises from the flow of investment funds. In a rising market, there are many investors flush with liquid cash or investment funds chasing a limited supply of investment real estate.
As a result, this creates upward pressure on market value for both buyers and vendors. If a willing buyer and willing vendor agree on a price, the market value is created. The vendor wants to maximize the sale price while the buyer wants to maximize the return on investment.
For the buyers, the price they pay affects their return on investment which can be determined through the ratio called capitalization rate or commonly called the cap rate. This cap rate can be defined as the annual net operating income for the property divided by the price. Alternatively, as a simple definition, the yield on investment is the current level of net operating income a buyer(s) will achieve at their specified purchase price.
There is a risk
As a lender, there is the risk that I will use a different cap rate to underwrite the property when compared to the cap rate generated by the purchase price. I must caution that this isn’t because we do not agree on the purchase price, but because as lenders we underwrite conservatively.
Our underwriting perspective reviews the property from a worst-case scenario. I look at a property as if the current owner defaults on the mortgage – I then take possession from the owner and enter the market to sell the property.
Upon default of the mortgage, my mortgage documentation allows me to take the property as security for my outstanding mortgage. In this bullish market, it is unlikely that I would suffer a loss on the proceeds from selling the property to repay my mortgage. However, if the market changed from bullish to bearish, the cap rates determined by the vendor and buyer may rise to a higher level (i.e. from 6% to 10% for example).
Since the relationship between cap rates and market value is inversely proportional, then a rise in cap rates will reduce the market value of the property.
Lender won’t cover the loss
In a bearish market, there is a possibility the market value could be less than the balance of the outstanding mortgage. If I have to exercise my rights under the mortgage, a loss occurs and someone has to cover this loss – and it won’t be the lender. The lender makes sure the owner of the property covers the loss and if the owner cannot, then his or her credit-worthiness can be affected for many years to come.
Lenders have long memories of bearish markets and times where we were forced to act as property managers, but the market may not. Best to keep in mind the bearish markets of the late 1980s and early 1990s. Interest rates rose to double digits, cap rates increased and market values dropped. Situations occurred where the market value was considerably below the outstanding mortgage balance and the losses so substantial property owners gave the keys to the lenders to look after the property.
I have little desire to be a property manager and would be less likely to lend money again to an owner handing me keys to manage it.
So listen to your lender – not only do we act judiciously form our own end, but also with the best interests of the buyers in mind as well.
Darryl Bellwood is a Director of Commercial Lending with First National Financial, Canada’s largest non-bank lender. He is active in most markets in the country with a focus on investment real estate. All feedback is welcome and he can be reached at [email protected].