Be aware that cap rates to a lender can mean something different than to an investor

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Current Challenges in Commercial Real Estate
with Regard to Declining Interest Rates and Cap Rates
I was asked by an out of state colleague what the current challenges are in commercial real estate and I thought
it wouldn't be a bad idea to also memorialize my response to him in the form of an article here on Linkedin.
Everyone in this industry already knows that while low interest rates are attractive to commercial real estate
investors, they also drive down cap rates on properties.
What many do not think about or consider is the following.
To investors, cap rates are for the most part a measure of return on real estate to compare against returns on
competing investments.
To lenders, a cap rate is for the most part not just a measure of return for the investor but also a measure of risk
for the lender and the lower cap rates go (up to a point) generally means either the investment has a
commensurately lower risk factor or the return and thus perceived risk is artificially being driven down by other
factors (i.e., Fed policy, etc.). If a cap rate on a property is comparatively too low for any reason, for example the
property is near the beach or has some other highly attractive attributes (credit tenant(s) on long-term lease(s), etc.),
the risk to a lender from leverage is somewhat eliminated because high leverage and low cap rates are mutually
exclusive with each and can't co-exist under traditional commercial real estate loan underwriting guidelines
requiring say a debt service coverage ratio of 1.3 and above for reasons seasoned industry professionals already
know.
Here is where things get tricky in the current market or any market with historically low interest rates that some
might consider to be artificially generated. If cap rates are lower than the risk a lender thinks is commensurate with
that cap rate, then low cap rates can conversely also mean higher risk (to a lender). Lenders are especially cognizant
of how fast the economics of income property can change when a loan is funded at a low cap rate and rates later
rise with a later drop in lease rates (a lagging indicator in an economic slowdown because most leases are term
leases).

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Lenders have ways to mitigate risk on properties whose cap rate is too low in their opinion and it's almost never
transparent (unless you are pushing for maximum leverage and then you'll find out quick). Lenders during the
underwriting process can impute a vacancy and expense factor that does not match the appraiser's, and impute their
own cap rate to reflect the risk they foresee to drive the leverage lower.
Borrowers and their brokers are also almost never aware (unless by accident) of what communications are
occurring between a lender and its appraisers (including independent fee appraisers) concerning any disputes about
the final value of a property or any of the many independent factors driving that final value. This is not to say the
lender's concerns are unfounded. While a lender can't explicitly tell an appraiser what factors to use in arriving at
any final value, every lender has the right to perform its underwriting according to its policies (that naturally change
to meet changes in the market) or to underwrite any particular loan differently under the latitude and discretion it
has to mitigate any additional risk it foresees. What many borrowers and their brokers don't know (because it
ultimately didn't affect loan proceeds) is that when a loan is funded by a lender at for example 60% or 65%
leverage, the lender's appraisal review value will sometimes be lower. So oftentimes when a loan is funded at 60%
or 65% leverage, the lender will book the loan internally reflecting it at say 70% or 75% leverage unbeknownst to
either borrower or broker. Why is this important? It's important because without knowing you may get a false sense
of security about the way the lender feels about the low cap rate on the property you just financed and you will
never know how close you may have come to having your loan proceeds cut back (which could complicate a 1031
exchange).
The bottom line is to always be cognizant of the fact that investors and lenders do not always look at cap rates
for entirely the same reasons.
This article concerns investment properties only. SBA loans are looked at somewhat differently because the
tenant/owner-user's income is also factored in.