Ed Boxer
Principal, Essex Financial Group LLC, Denver
As many readers may recall, almost $300 billion of securitized commercial loans were made from 2005 to 2007. Most of those loans were 10-year balloon mortgages. There was a lot of hand wringing in 2015 by many financial professionals concerned that the loans would not underwrite to fully refinance the outstanding loan balance. Many loans back then featured several years of interest only followed by a 30-year amortization schedule (many loans in 2007 were 10 years interest-only). Well, so far so good … according to Trepp (a company that tracks commercial mortgage-backed securities loans), of the $80.9 billion in nondefeased (paid off early) loans that matured through February, 94 percent paid off without any significant losses whatsoever.
Fortunately, the real estate cycle and overall economic conditions provided enough value appreciation and net income growth in all major property types that the market successfully refinanced the large amount of maturing volume in 2015. The $80 billion of CMBS loans maturing in 2015 contributed to almost $100 billion of new CMBS issuance in 2015. The big question remains: What does it look like going forward for the remaining wave of maturing loans in 2016 and 2017? Property valuations remain strong and net operating income growth is stable to trending up slightly, so it appears that all else being equal, the next wave of maturing loans also will be refinanced with a straightforward new first mortgage.
Well, Trepp dug a little deeper into the variables affecting the securitized market and noted the following macro events that are creating headwinds for the CMBS market’s ability to handle the next seven quarters of increasing maturing volumes. Trepp correctly noted that, “Oil’s slide since last year has hammered high yield, fixed-income bank balance sheets and energy company stocks. Pair that with the first Federal Reserve rate hike and growth concerns in China, and the result has been quickly widening new CMBS issue spread.” In addition, banks are pulling back on providing lines of credit to many CMBS originators, forcing smaller shops to go out of business. Banks also are reducing their exposure to CMBS paper that diminishes secondary-market liquidity. Given these factors, the market is more uncertain for the over $200 billion in loans coming due between now and 2017. It should be noted, however, that spreads have narrowed recently but they remain well wide when compared to last year at this time.
Trepp then turned its attention to the actual data available on maturing loans and applied current underwriting metrics based on cap rate, loan to value, debt-service coverage ratio and debt yield. Higher interest rates were used based on current CMBS spreads. For DSCR, the rate hike affects the loan rate directly, increasing debt service and decreasing DSCR. For LTV, the rate hike is assumed to inflate cap rates and, consequently, decrease appraised value and increase LTV. For debt yield (NOI/loan amount), instead of changing the maturing loan debt yield, the threshold for qualifying for refinancing was raised by the assumed interest rate increase.
Those measures were then compared to the average property type/metropolitan statistical area levels of recent originations. DSCR is not a problem even with higher imputed interest rates for 85 percent of the loans maturing. Current rates are still lower than rates maturing in 2016. The story is a little bleaker when looking at the LTVs and debt yields of these maturing loans. These tests eliminated 43 percent of maturing loans from being refinanced at current loan balances. Only 52 percent of maturing loans meet their respective debt yield thresholds assuming no change in rates. If debt yields increase 100 basis points, 59 percent of loans will fall below the minimum required debt yield.
According to Trepp’s analysis, on a DSCR basis, almost $31 billion in maturing loans will not be able to refinance their entire balance. On an LTV basis, almost $93 billion would need additional equity in order to refinance at current income and cap rate levels. The number increases to $100 billion based on the debt yield parameter.
The owners of these “challenged” assets will need professional assistance to help them restructure the capital stack. Clearly, some form of additional equity or subordinate debt will have to come into the picture when the current loan is paid off. “Cash-in” refinancing will be required for these assets.
One solution that may appeal to many property owners with maturing CMBS debt will be to refinance up to 85 to 90 percent of the capital stack based on today’s property value. Some lenders will issue a new senior mortgage at 75 percent LTV and then layer in an additional 10 to 15 percent of mezzanine debt (subordinate debt) that is co-terminus with new first mortgage. The incremental cost for the additional leverage is generally around 12 percent. The mezzanine debt is not exactly the same as a second mortgage. It is in second position behind the senior mortgage but it is not recorded as a second mortgage. Mezzanine debt, instead, takes an assignment of partnership interests that gives the lender the right to take control of the borrowing entity without going through the foreclosure process.
Real estate investment banking firms, such as Essex Financial, are prepared to provide the best solution that meets the property owner’s objectives for the asset. Fortunately, there are also many non-CMBS lenders prepared to provide higher leverage for many stabilized properties. Bridge, mezzanine debt, preferred equity and other nonbank lenders are well positioned to come to the rescue of many of these highly leveraged income properties. These nontraditional capital sources need to be properly vetted before going down the road with them. Firms such as Essex have excellent relationships with lenders of this type who are more than willing to review and fund new capital for attractive assets.
