Billions of dollars in commercial mortgage-backed security loans are set to mature in 2023 and 2024. Many of these loans were originated when rates were much lower and are now coming due in a climate of high inflation and high interest rates.
Despite current market conditions, these borrowers still need to refinance. Many are eligible for extensions with their current lender. But these extensions will likely carry substantial prepayment penalties, yield maintenance or deposits for years to come.
“Although interest rates are clearly higher today compared to a few years ago, there still are low-interest loans available. The trick is to meet the qualifications.”
Other borrowers are facing a different problem. Their income, coupled with a higher interest rate, won’t meet debt-service-coverage ratio (DSCR) requirements, which is the division of the annual net operating income by the annual debt service. This figure needs to be above 1.0 to refinance the full loan amount at a preferred interest rate or term. These borrowers are at risk of maturity default.
The crisis these borrowers are facing represents an unprecedented opportunity for commercial mortgage brokers to guide them safely to a solid loan solution, earning their trust and business in the process. Understanding the options upfront and knowing how to use them in different borrower circumstances will properly arm brokers to successfully shepherd clients all the way through to funding.
Set the stage
A borrower’s options will rely in part on asset class. Industrial and multifamily real estate remain robust. Retail is steady, especially if anchored by large, creditworthy tenants. Strip retail centers with smaller and sound tenants also can be attractive, even without anchors. Indoor malls are more difficult but fundable if occupancy rates are high and the tenants are financially stable.
“The crisis these borrowers are facing represents an unprecedented opportunity for commercial mortgage brokers to guide them safely to a solid loan solution, earning their trust and business in the process.”
Other asset classes, such as office buildings, are more of a challenge. This is not news. But rather than assuming no office property is fundable, brokers can help clients explore options to make a refinance deal more appealing. These strategies can work with many hard-to-fund loan requests.
For example, the borrower may own other properties in addition to the one securing the loan that is set to mature. These additional properties sometimes can be leveraged to cross-collateralize the subject property with the net effect of reducing perceived lender risk.
If the borrower can plan ahead, many problems can be mitigated. For instance, when occupancy is down, the focus should be on ramping it up before the loan comes up for renewal. This could mean making temporary rent concessions or offering other incentives — such as tenant-specific property improvements — to attract new tenants.
Existing tenant leases should be extended for as long as possible so that lenders are confident in the property’s income streams. An important metric for brokers to consider is the weighted average lease term (WALT) score, which is a calculation of all remaining lease terms at a property weighted for the size of each tenant. Lenders typically want to see a WALT score of at least four years. Brokers who advise borrowers on this metric ahead of time can help them correct course when needed, which can make the difference between a maturity default and successful refinance.
Seek tenant stability
Tenant quality is crucial when refinancing occupied properties. Borrowers should obtain tenant financial reports as part of their due-diligence process, then share them with brokers and lenders to underscore the strength of their tenants and resulting rental-income streams.
In addition to financial stability, tenant suitability is a factor. For instance, an owner of an office building should choose tenants whose employees can’t work from home, making office space invaluable. This includes health care, retail, construction and manufacturing companies, to name a few. When approaching a maturity default in today’s market, startup tenants should be avoided if possible, but any tenant is better than none. Credit tenants are preferred.
Landlords should also consider repositioning. For example, a client transitioned his office building into a biotechnology-only facility. He invested in focused tenant improvements that were needed to attract strong tenants in the biotech industry. Because he was successful at leasing it out and increasing occupancy, he ended up with a competitive loan package in a mortgage environment that is often hostile to office properties. This process was started long before the loan matured.
Adaptive reuse is another viable strategy for properties in underperforming asset classes. Many borrowers are opting to transition offices or sluggish retail spaces into multifamily homes. Again, this process should start long before the loan matures.
Low-interest options
Although interest rates are clearly higher today compared to a few years ago, there still are low-interest loans available. The trick is to meet the qualifications. These lower-interest options typically take longer to close — 60 to 90 days — so borrowers need to start planning well before the current loan matures.
Borrowers shouldn’t put precious time and money into a loan application that is destined to fail. The most likely roadblock is meeting the DSCR threshold. If the ratio is 1.0, the landlord’s cash flow is at the break-even point. Most lenders want a cushion.
The net operating income needs to be sizably larger than the proposed debt service. Borrowers can expect a DSCR requirement of 1.3 to 1.4, so they should anticipate the need to increase income or lower expenses whenever possible.
A common misstep for borrowers is to begin withholding payments as the loan reaches or passes maturity, or while the refinance is in process. Borrowers who pursue a refinance, especially a low-interest option, must keep paying their current lender. Late or missing payments at this juncture, even as the loan matures, can cause them to be disqualified.
Other loan types
A hybrid or “short money” loan can buy some time while the borrower waits for long-term rates to stabilize. This cross between a long-term, low-interest loan and a bridge loan offers a lower interest rate than a typical bridge product, with a shorter term and a shorter prepayment penalty period than a permanent loan.
This type of loan can work for a borrower who does not need to lock down long-term financing because they plan to sell or repurpose the property. With a hybrid loan, the borrower can avoid maturity default without committing to a long-term loan with stiff prepayment or yield maintenance penalties.
For some borrowers, a traditional bridge loan might be the best option, despite the higher interest rate. If the property has strong fundamentals but the borrower needs rates to go down before meeting the DSCR for a permanent loan, bridge financing fills this gap. The advantage is that interest-only payments will help keep debt service in line without stressing the borrower’s bottom line. With a bridge loan, the lender can build in an interest reserve to offset any potential cash shortfall.
Bridge loans, which are short-term loans designed to provide financing during times of transition, also offer the advantage of a quick close because underwriting requirements tend to be lighter. But these borrowers still need to be prepared to defend their projections.
It’s also important to consider the exit plan once the bridge loan matures. Lenders will want to know now what the plan is two to five years down the road. How will this loan work when exiting into long-term financing with a 5% to 6% interest rate?
Consider the competition
Lenders today want to see lower leverage to offset the risk of deflating property values. Borrowers may need to bring more cash to the table. Now is not the time to float a 90% financing request.
To bring more money to the deal, a borrower can offer to cross-collateralize, pay down debt or make a larger downpayment. As painful as that might be, it can pay off in the long run. It’s a much better alternative than losing the property, and the borrower can look to pull cash out later when rates improve. Lenders already are seeing an uptick in refinancing requests. The easy ones tend to drop into the funding queue quickly. To compete for these funds, borrowers need to make their loan package stand out.
Construction loans and large property sales are typically supported by an offering memorandum (OM), a legal document issued to potential investors in a private-placement deal. These documents come with all the bells and whistles that make a case for a new development or property sale. While this is not typically done in refinance situations, there is value in compiling this level of research and presenting answers to obvious shortcomings before a lender has the chance to decline.
Borrowers should devote attention to the economic and geographic environment of the subject property, selling the lender on the merits of the location and reducing perceived risks. For example, a tertiary market location is difficult to fund. Lenders prefer major metro areas or secondary markets. Borrowers in small cities or rural areas will need to formulate a story and mitigate factors to avoid a quick rejection.
Factors such as rent comparisons weigh heavily on a lender’s decision to issue a term sheet. An OM that shows how current rents compare locally, along with growth projections if rents are at or below market rates, can assuage a lender’s fears.
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Commercial real estate owners who need to refinance loans in the next two years are facing lower revenues and higher interest rates, which in turn will impact the DSCR needed to refinance. For many, qualifying for long-term replacement financing will be a challenge. But loan options exist for borrowers who are willing to be flexible. Mortgage brokers who are proactive can seize this opportunity to build client trust and increase deal flow. ●
