Refinancing Maturing CMBS Loans
Between now and 2018 more than $700MM of CRE loans will mature, including more than $205MM originated by CMBS conduit lenders. At its peak, near 2006-07, the CMBS lending machine accounted for nearly 30% of the entire commercial and multi-family debt sector. Although impressive with its growth, the natural question around that growth is what did the industry have to go through in order to gain so much market share so fast. Likely answer…. a significant drop off of underwriting standards. At the granular level, individual firms were likely progressively more aggressive as the growth continued towards its peak, meaning that the most lax underwriting standards were present in the making of the 2007 loans – including longer I/O periods, higher LTV’s applied to higher purchase prices, mezzanine debt on top of the senior tranche, and sizing on a coverage constraint using pro forma rents. It’s darkest before dawn! Thus, 2017 CMBS refi’s may be the most difficult of them all if the current capital markets don’t loosen up even more than they already have, and property values keep climbing.
Of the maturing CMBS loans, the majority is expected to refinance with sufficient proceeds to pay off the remaining unpaid balance of the existing loan. Supporting this expectation has been rents growing at an annual pace of 2-2.5% and, according to Moody’s/RCA, asset prices more than 12% above the pre-crisis peak. One caveat is that the major property markets demonstrated a 29% price appreciation above the peak, making secondary and tertiary markets something well below 12%. Although, according to Trepp, only 33% of maturities are located outside the top 25 MSA’s.
Trepp data says 96.5% of maturing loans through 2018 meet the 1.2x DSCR threshold at the current average interest conduit interest rate of 4.5% that existed in November 2015. However, the logic fades in an increasing interest rate environment. If the average rate grew to 5.5% that figure drops to 94%, and at 6.5% it 89%.
Of specific property types, office and retail properties face the greatest refi risk. $65B of office loans mature with nearly 21% not covering at 1.2x if average interest rate climb to 6.5%. And $63B of retail loans are maturing and nearly 15% won’t cover at the same rate. However, meeting LTV constraints is possibly the more significant issue. In 2015 the average underwritten LTV ratio for CMBS was 63% and ranged between 62% and 70%.
Although cap rates are not on the rise (many market pro’s don’t believe they will be before bonds increase 200 basis points or more), were seeing non-core assets in secondary and tertiary markets receive harsh treatment from appraisers. Specific areas of concern addressed by appraisers have been tenant rollover risk, including capital for tenant improvements and leasing commissions, deferred maintenance accumulated over the property market recovery period, and higher capex reserves for a property now 10 years older than it was for the previous refinancing.
Anecdotally, over the past four years, we have observed the main causes of refinance failure to include:
Loss of major tenant occupancy and thus overall NOI
Little or no amortization of principal over the term of the loan
An acquisition price at the top of the market
Initial high loan to value financing, including mezzanine debt
What’s clearly in front of us is a number of headwinds that could potentially make refinancing the CMBS maturities at par difficult. Perhaps most unforeseen has been the meltdown of the CMBS market itself. Three years ago dozens of newly organized origination shops landed in NYC to get their fair share of the wall of maturities (42 at one point). With expectations now becoming unrealized for how many loans could be refinance with a CMBS execution, some of the less committed shops are now closing. A few opinions we hear from the street estimate the industry will be left with no more than 15 origination shops in the not too distant future. Yield spreads are historically wide and don’t appear to be abating any time soon, given the turmoil in the corporate bond market and the looming risk retention rules for originators that will kick in in December.
So if the CMBS market won’t refi these loans, can we expect the banks to step into the space? Maybe, but banks are facing regulatory hurdles of their own with new Basel III implementation dis-incentivize banks from CRE lending. To make matters worse for bankers are overzealous regulators practically demanding the banks don’t do anymore CRE lending, and even get rid of some they currently hold on book. A significant reduction in activity from banks and conduits, is opening a hole for private, un-regulated lenders to step into.
Another serious concern for borrowers with maturing CMBS loans is that the real estate recovery we have experienced since 2009 has not included all geographic sub-markets in the U.S. Properties located in markets that have not kept pace with general economic and job growth (including energy markets) are likely to face rent roll issues, including near term rollover and anchor tenant departure. Heavy demands for tenant improvement and leasing commission dollars only promises to put even more pressure on refinance proceeds. Not to mention deferred maintenance and capex dollars.
Lastly, I am hearing many “on-book” lenders comment now of their hesitancy to provide fixed rate financing given how low rates are today. At the very least, lenders are talking about instituting floors to accommodate a philosophy of rates rising at some point.
For me, the coming maturities in 2016-17 can be viewed as if on a continuum. On the left end of the continuum are the lowly leveraged, high covering loans that will easily refinance at par. Good properties in sustainable markets owned by conservative borrowers. However, on the right end of the continuum are loans that are sure to come up short, with current coverages in the .5 to .9 range and LTV’s 80-95%. These loans will either have to be worked out by the special servicers or sold to separate investors as note sales. As the individual trusts approach the end of their assets, either through defeasance, payoffs or workouts, controlling classes are changing and special servicers are changing their attitude toward note sales.
In the middle of this continuum are the “bubble deals”, or loans that could go either way – refinance at par or workout.
For owners unable to refinance at par there are a few alternatives:
Sell to a third party if the property value exceeds the UPB. This strategy involves capital gains tax issues which could be potentially painful if the current asset was used in a 1031 exchange.
Negotiate with the servicer – Forbearance, DPO, A/B, Payment modification, note sale
Explore creating refinancing strategies with a host of lenders, many of whom are far more creative since they are free from government regulatory oversight.
For many in this category, the need to be creative with the next capital structure will be high. Options include lenders who will provide high-leveraged senior mortgages (80-85% LTV), using a blended rate of capital for a senior loan to approximately 65-70% and mezzanine pricing on anything above. Other options include using two sources of capital for the senior and the mezzanine debt, which will include a fun exercise of negotiating an inter-creditor agreement. Mezzanine lenders will at least want to see a 1.0x cover and no more than 85% LTV, with a good story backing up your projections for getting coverage to something closer to 1.2x in 3 to 5 years. A more draconian measure is to include new equity capital in a recapitalization of the partnership so that less debt is required. These equity providers are not lenders so they will be looking for a dilution of the partnership favoring them of course, or dividing the partnership into differing classes with the new fresh capital having preferential treatment on future disbursements. This strategy is gaining traction with TIC borrowers who possess a very low tax basis in their investment and face tremendous tax recapture if the TIC loses the property to foreclosure.
A few suggestions for property owners owning properties used as security for a maturing CMBS loan:
Start the refinance process early. For the coverage and value challenged loans there will be a number of puzzles that will need to be solved. In addition, many of the capital providers today are different, and their strategies for deploying capital are different. Who and what you knew in the capital markets 10 years ago is likely different today.
Get counsel from a well-travelled capital markets expert that can provide a big-picture perspective and a lot of alternative approaches you might take.
Communicate with the servicer as you move down the refi/workout road.
If your loan is wobbling – 1.05x cover and 85% LTV – you might want to enlist a borrower advocate that can perform the hand to hand combat with the special servicer that you will have to face.