Borrowers: Important considerations for debt capital decisions in 2015 and 2016

Susan Branscome

Susan Branscome

Guest post by Susan Branscome, NorthMarq Capital

Commercial real estate and multi-family property owners manage all kinds of risks owning properties: tenants, municipality regulations, operating expenses and capital expenses.

One of the biggest risks in managing a portfolio of properties is making sure the debt capital is right for properties. Most properties have 70-75 percent of the capital stack in debt so how the property is financed is important to both the success of the property and the owner.  There are many choices available today unlike the recent Great Recession.

There are many factors which impact debt capital. Capital markets shift weekly, sometimes daily. Lenders’ appetites for loan origination, where treasury yields and swap rates are, what the Fed is doing or going to do, and of course the international markets’ impact on the US debt capital market and economy. Where do you begin?

Types of lenders

The predominant lenders which finance commercial real estate are commercial banks, life insurance companies and CMBS/conduit lenders. In the case of multi-family, of course Freddie Mac and Fannie Mae play a huge role.

Commercial banks are excellent sources for financing commercial real estate during construction or renovation.   Many borrowers utilize commercial banks heavily given short-term interest rates are so low. If guaranteeing the loan and recourse are not issues, interest rates as low as 2.5-3.0 percent is very attractive. Borrowers would be wise to consider how much time is involved with submitting information to banks quarterly and dealing with extending maturities so often.

Life insurance companies are excellent sources for long-term, fixed interest rate, non-recourse debt capital to the marketplace on most property types.   2015 has been a year of life companies reaching their allocations through originating some of the highest quality, lowest leverage loans in history. This is not expected to change in 2016 unless competition enters the market causing life companies to increase the amount of leverage offered.

CMBS/Conduit lenders have re-entered the market and are offering some of the highest loan amounts on office properties and hotels. These lenders continue to struggle offering efficient and predictable origination processes, however. Today’s pool investors, especially those with the highest risk position in the pool (B-piece buyers) are scrutinizing the individual pool loans heavily, making sure loans are well structured around potential risk. Although in 2005-2007 borrowers were able to secure 80 percent financing at spreads as low as 110-120 over swap yields, living with the hassles of conduit servicers has caused many borrowers not to return.

Originate the loans with mortgage banking companies which can service these loans so you have a point of contact for future requests. As I guide borrowers in CMBS financing I tell them, “It’s the wild west in this market” and you do not know your deal until you close the loan. Make sure all future requests are outlined thoroughly in loan documents assuring that there are rights around response time by the servicer. Some conduit lenders are excellent and quite predictable and those are the ones with which we recommend borrowers enter into 10-year relationships.

The best lender for a given property will depend upon the borrowers’ tolerance for recourse risk, interest rate risk and leverage expectations. It is always a good idea to spread portfolio debt capital among many lenders so as not to be subject to the investment whims of one. Attitudes toward commercial real estate by lenders can change over time and more lender relationships are better.

 Loan term and amortization

Commercial banks offer construction loans, mini-perm loans, swap contracts and longer-term loans. Some banks even offer non-recourse loans although borrowers would be wise to look closely at loan documents assuring these are truly non-recourse loans. Conduits typically offer 10-year terms, and many have non-recourse bridge programs for interim financing and for those properties requiring additional funding for tenant finish and capital expenditures.

Life companies offer a wide variety of loan terms depending upon their sources of funds. Five-year, seven-year and 10-year terms, up to 20 to 40 year fixed rates are available today.   Rate resets are available also, 15-year loans with five-year rate resets are in the market.

Loan amortization depends upon borrower preference as well as lender requirement.   Some borrowers want to pay down loans as quickly as possible, others want as long an amortization as possible. 30-year amortizations are typical for conduits. Many conduit lenders are offering interest only for a portion of the loan term.   Life companies will offer typically 25 to 30 years on multi-family, unless there is some attribute of the loan leading to a shorter amortization request.

Float-to-fixed rate loans are available by long-term lenders giving borrowers the flexibility to float at low interest rates and lock long-term interest rates when they are ready.

Important loan provisions during the loan term

Most long-term loans have prepayment protection meaning there is a cost associated with paying loans off before the maturity dates. In recent years, borrowers have been dissatisfied with how high prepayment premiums have been on their existing loans as a result of significantly lower treasury yields than those present at the time of origination.

The opposite is expected to be true in the future. For example, if a borrower locks an interest rate at 4.5 percent, and rates rise as expected, prepayment premiums can be much lower, especially with a shorter remaining loan term. Conduit loans offer defeasance as a form of prepayment, which means substituting an alternative security instrument to real estate, US treasuries. Just like bank swap contracts, with defeasance there is a chance if rates rise enough, loans can be paid off at discounts. Many life companies can also offer stepped down prepayment such as 5 percent during a given year, dropping 1 percent per year thereafter.

Make sure you have assumption rights, and the ability to transfer among partners. Understand that lenders want strong buyers with good financial wherewithal and the ability and willingness to manage the properties. There will not be an automatic approval of the loan assumptor when the property is sold.

Request the allowance of second mortgage financing which offers the ability to use debt capital to fund property improvements. While many lenders prohibit junior liens, others may be open to this possibility.

Freddie Mac and Fannie Mae have excellent supplemental financing programs allowing borrowers in the future to secure more debt capital on properties as a result of value increases and amortization.

Future plans for property

Consider future plans for properties. Is the plan to hold the property? Sell it? Cap rates have dropped yet will probably rise with increasing interest rates. The property’s mortgage loan can be a critical part of the sale. If there is no loan prepayment premium, this can be a positive for all-cash buyers. As the maturity date is approaching, and refinancing is chosen, make sure the property is ready to finance based upon leverage level, strong leasing with staggered lease expirations and capital needs are addressed—all of these are important to lenders. Make sure that not more than 20 percent of the portfolio comes due in any one year mitigating the uncertainty of any one debt capital market.

The sale of a property may cause tax consequences even with 1031 exchanges in which the capital gains are deferred.   With debt, there are minimal tax consequences through a refinance or refinancing after a 1031 exchange occurs.

Leverage level

Naturally the lowest interest rates are available for the lowest loan-to-value ratio deals, typically offered by life insurance companies. Lower leverage on the property though can be an issue in a future sale of the property during the loan term.   The loan will have prepayment protection. While a lower than market assumable interest rate can enhance the sale of the property, a purchaser will need more equity to accomplish the sale limiting the universe of potentially interested buyers. Consider this as you are leveraging the property, perhaps it is better to leverage the property to a maximum level even if the interest rate is higher.

Conduit lenders are offering up to 80 percent LTV loans on the best multi-family properties. Mezzanine debt is also available today, allowing up to 85 percent overall financing.

Interest rates

No one really knows which direction long-term interest rates are going and when. As it has been said, “Nobody is smarter than the market”. If the interest rate works, lock it. While we have experienced a recent rise in treasury yields, interest rates are among the lowest in history and it is a mistake to take them for granted. If a borrower plans to hold the property and wants to manage interest rate and recourse risk, lock the interest rate. Should the choice to sell the property in the future occur, the assumption clause or prepayment options allow this. Borrowers should choose the leverage level they want in a property, then lock the interest rate for as long as possible. This allows them to manage future cash flows in the property without worrying about increasing interest rates.

2016 is an election year and during the past thirty years, interest rates have remained stable during election years or shown slow, small declines during the year. Many borrowers continue to maintain low, floating interest rates with banks at 200 basis points lower than long term rates. The Fed will ultimately increase short rates. The gap between short rates and long rates will probably narrow.

Recourse vs. non-recourse

It has been surprising that despite low short interest rates, borrowers continue to guarantee loans. The incidents of lenders using borrowers’ loan guarantees during the downturn as leverage for loan principal reductions and other matters are fading from borrowers’ memories. Property owners would be well advised to manage recourse similar to managing interest rate risk. Manage contingent liabilities through financing debt when possible on a non-recourse basis. Banks want recourse on loans, yet they also expect borrowers to have a manageable global portfolio liability level.

2016—what to think about

We have refinanced many loans prior to maturity, often with the incumbent lender.   These old interest rates often start with a six. Many lenders offer forward commitments and the ability to lock interest rates now, mitigating future interest rate increases. Any loan prepayment premium can be added to the loan proceeds with the new loan or the prepayment could be embedded in the new interest rate. The amount of time it takes to pay back this prepayment can make a lot of sense. If borrowers have maturities upcoming during the next two years, it’s not too soon to consider refinancing early.

Remember, a record level of loans are coming due in 2016 and 2017. Lenders will be refinancing loans in their portfolios and will consider these new loans counting toward their budgets. The result will create less demand for new loan opportunities and affect receptiveness to new loans. Also borrowers who have previous relationships with lenders are given priority.

The commercial real estate debt capital market is complex and ever-changing. There are many choices of lenders, types of loans and loan provisions. Seek help from a trusted mortgage banking professional to guide you.

Susan Branscome is managing director of NorthMarq Capital’s Cincinnati office.

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