What is Loan Sizing?
Loan Sizing is the underwriting process by which commercial real estate lenders estimate the appropriate amount of financing to offer to a particular borrower.
Table of Contents
How Does Loan Sizing Work in Real Estate?
In the commercial real estate (CRE) industry, the reliance on debt financing to fund projects is an inherent attribute of the strategies used by investment firms to achieve their target returns.
If access to “cheap” debt capital in the credit markets is readily available, the real estate market tends to exhibit higher transaction volume (i.e. the total number of transactions that occur in a given period) due to the rise in buying power.
The cost of debt, or interest rate pricing, is one of the core drivers of market demand from buyers, which has broad implications on property valuations.
The more leverage used to fund the purchase of a property, the greater the return on the investment – all else being equal.
Why? The equity contribution required by the commercial real estate investor declines, causing the potential upside on the return on equity (ROE) to increase at exit.
- Positive Leverage (Project Return > Cost of Debt) → Higher Return on Equity (ROE)
- Negative Leverage (Project Return < Cost of Debt) → Lower Return on Equity (ROE)
Hence, real estate investors have the economic incentive to reduce the size of their equity contribution on the date of initial purchase as much as possible.
Contrary to an equity investor, the return on senior debt is “capped” since the sources of yield are the receipt of periodic interest and principal amortization.
Therefore, commercial lenders prioritize capital preservation, which entails mitigating downside risk to avoid incurring a capital loss on a financing.
How to “Right-Size” a Commercial Loan
The underwriting process differs per lender and is affected by various factors, such as the real estate project type (e.g. strategic value-add acquisition, property development project), the track record of the borrower requesting the loan, and current market conditions.
The centerpiece of the underwriting process is loan sizing, whereby a commercial lender performs a cash flow analysis of the underlying property to determine the maximum loan amount (“ceiling”) to offer to a potential borrower.
The implied maximum loan amount, however, should not be interpreted as the right amount to provide. Instead, the maximum loan is merely an upper parameter to not exceed.
Based on insights derived across the entire underwriting process, the size of the loan can be adjusted downward accordingly to ensure there is a “cushion” for underperformance.
The size of a commercial loan, such as a CMBS conduit loan, is predicated on the property’s cash flow, or net operating income (NOI).
But unlike CRE investors, who focus on the pro-forma NOI at stabilization, lenders are far more focused on the historical cash flow of the property, as well as the downside case in the pro-forma forecast.
From the perspective of a lender, an overly conservative analysis is preferable to an overly optimistic analysis, since a lender is a debt investor.
While there are various external factors that can cause the yield earned by the lender to deviate from original expectations (e.g., interest rate risk), the one risk deemed more manageable is the risk of default.
Generally put, the quality of a given real estate asset, like an office property, is the primary determinant of the total loan size (and thus, the focal point of the analysis).
The reason? Commercial lenders tend to be conservative rather than yield-oriented, and require the borrower to pledge the property as collateral as part of the financing arrangement (i.e. lien).
In the event of default – i.e., if the borrower misses a scheduled interest payment or is unable to repay the principal in full at maturity – the senior secured lender has a rightful claim on the asset.
