Quote from @Giles D.:
Appreciate the brutal honest! Understand that people trust other people to do what they say they were going to do.
The fact that IR's accelerated outside of the worst case scenario models, even outside of a 2 SD, didn't have anything to do with it nor the fact that the local jurisdiction decided to extend the covid moratorium for an extra year resulting in no rent collection for a large portion of the MF property, was certainly factors not considered when applying basic math to the forecasting.
I may have been too dumb to understand that I couldn't control 2 unprecedented future events, please educate us on how you do it as I for one would be fascinated to learn how you do it. @Carlos Ptriawan
Usually I'm attacked when I say thing like this, but well yes I'll try to explain from the big picture and mini picture here and kind of mixed bag PoV okay ;-) lol.
in big picture, back to basic
first of all , the relationship between the borrower and the lender ; are never equal.
The risk modelling is vastly different from how a loan is structured, no matter what it is.
second, All assets have intrinsic value and extrinsic value. A 50x more beautiful single family in Montgomery AL would be priced 1/10 compared to a similar house in CA. There's ceiling in CRE, but no ceiling in single family.
third,the valuation of CRE is solely follows the actual rent it received
so lets go back to the first one , this has nothing to do with interest rate at beginning, but lets give comparison.
A fixed-rate 30 years with a 2% rate, even without an interest rate hike, the borrower would have a better return profile than the lender. The lender is throwing us money for free. We know SF owners would have a better risk/reward profile because appreciations are typically 150-200% higher than inflation rate. Even with increasing rate, home price may not go down because it's a fixed rate for 30 years. This is the safest loan type for borrowers in the planet.
On the other hand, CRE appreciation is limited by the rent factor. The lender is always winning or has way way better risk/return profile compared to the borrower (GP/LP). Because a CRE valuation is based on income, then we make a valuation indicator called cap rate. Cap rate is essentially just a ratio between income and price to buy. Essentially, on this model, the model only works if the cap rate has a slight positive margin compare to the interest rate. In 2009 we have a cap rate of 8-9% for certain asset class and the interest rate is 3%, this gap is actually one that makes you money.
However, and this is the big however if cap rate is falling high enough (aka) valuation going up too high too fast because of overbidding (such as in 2020 era), then even without an interest rate hike, your project risk profile is way higher because your upside is way limited. Why the upside is limited? because next buyer can't justify buying your asset in cap rate 1 or 2 because if you do then essentially there's no return given to investor.
Now, what is the most riskiest type of lending ? For the borrower, the riskiest are short-term loan, the lender approves the lend with DSCR 0.20-1.5x, but I checked it's very typical to have DSCR 0.80x. In these circumstances and may bridge lender and CRE debt rating agencies, already know from the beginning that the property has bigger chance of going to fail. I But because the lender can allocate those riskier loan into bunch of other mortgage loan that's more "safer", the lender can somehow reduce their risk, also by requiring the borrower to purchase interest rate caps as hedges and so on. So lenders are way smarter than the GP when it comes to riskier loan.
In 2022, Fed increased the rate by 500 bps, automatically asset pricing should fall by 30-40%. This is very straightforward because those loans are short-term. A 100bps interest rate hike is equal to 5-10% reduction in asset valuation give or take. We're in a territory where the cap rate is 3-4% and the interest rate is 7-9% , of course the equity would be wiped out.
If one fellow has good understanding about how the lending work this problem is very easy to be avoid. Again, it's not 100% of the fault of the GP.
