As bond and equity markets brace for a small uptick in rates courtesy of the Fed, will this compound the issues facing commercial mortgage borrowers who need to rollover their loans?
A quick look at the chart below illustrates the scope of the potential problem facing borrowers with the $300 billion or so volume of commercial mortgage loans originated in 2006-2007 that will likely need to be refinanced this year and next.
And for those familiar with commercial real estate loans you know only too well that banks are not all created equal when it comes to their appetite for specific property types and loan metrics!
'Given the sheer volume of CRE loans that will need to be refinanced over the next year or so combined with the uncertain interest rate environment, it is critical to know your lender and to make sure that your property-type and loan parameters are in that institutions sweet-spot before beginning the process!'
'A borrower most certainly does not want to invest critical time and potentially money into the underwriting process only to learn that the particular lender where they're applying was the wrong place to be from the start' - Diego Pinzon, Signature Bank, firstname.lastname@example.org
So what is it that makes a commercial mortgage loan different than a residential mortgage loan?
For those who may be unfamiliar with commercial mortgages, the vernacular and buzz words used are much different than those found in residential loans.
In a residential loan words such as appraisal, LTV, DTI and credit quality of a borrower are key factors when underwriting a loan. And if a loans parameters fit into a certain box, the loan will typically be approved.
And for residential appraisals, like properties in close proximity to each other will tend to be valued about the same give or take a few dollars depending on a properties condition and the bells and whistles being offered.
In commercial the buzzwords and acronyms differ in many ways from residential including names such as NOI, DSCR, cap rates and property type.
In addition, unlike residential appraisals, two identical buildings that sit side by side could potentially come back with very different values.
Some of the terms to consider in commercial real estate/CRE loans
DSCR or debt service coverage ratio: The amount of times that debt service is covered by the net operating income. Logically then this brings us to that very term, NOI.
NOI or net operating income: A simple calculation that, in addition to DSCR, is a key component when underwriting a CRE loan. 'Net operating income equals all revenue from the property minus all reasonably necessary operating expenses. Aside from rent, a property might also generate revenue from parking and service fees, like vending and laundry machines. Operating expenses are those required to run and maintain the building and its grounds, such as insurance, property management fees, utilities, property taxes, repairs and janitorial fees. NOI is a before-tax figure; it also excludes principal and interest payments on loans, capital expenditures, depreciation and amortization.' (Source)
Property Type: At various times in a real estate cycle lenders may or may not have an appetite/comfort level for the different commercial property types that include multifamily, office, warehouse, mixed-use, etc. And for properties such as warehouse and mixed-use some lenders mandate owner-occupied buildings while others may not. Further some property types including restaurants, dry cleaners and auto repair may require specialty lenders who focus on them.
Tenant Quality/Length of Lease: Does a property have a 'high quality' anchor tenant and if so what is the remaining term of the lease. And, with the shake-up in some sectors like retail, just how good is a box store that used to be considered a AAA tenant? For smaller buildings tenant quality and length of leases is still a key focus.
Capitalization or cap rates: Every neighborhood and property-type will have a cap rate associated with it representing the return an investor wants to earn for risking their money. As a simple rule of thumb if you divide a property's NOI by the cap rate you will get a general idea of what a commercial property may be worth. If you know the NOI and asking price you can derive the cap rate being used by dividing the NOI/asking price.
As fears of a Fed rate hike increase, no matter how minuscule it may be in the overall scheme of things, commercial mortgage rates would rise thereby increasing debt service costs. At the same time cap rates will also rise decreasing the value of property.
These two factors among others could make the prospect of a borrower receiving a affirmative underwriting decision for a commercial mortgage borrower more tenuous.
Consider also the concern that an uptick in rates will raise the likelihood of recession that may have lenders pulling in their horns, hesitating to make loans they consider to have even marginal risk.
This would likely affect the small-balance market in a disproportionate way.
'Interest rates would have to rise substantially for debt service coverage levels to become a refinancing issue during the next two years. Interest rates remain below where most loans were originated in 2006 and 2007.
The average coupon for CMBS loans that were originated last year through mid-November was about 4.5 percent. At that coupon, net operating income easily covers debt service for most loans and property types. However, last month, the Fed began to increase its benchmark interest rate that had stayed near zero since 2008. Movement by the Fed sets the tone for other interest rates and could portend an increase on the long end of the yield curve.
Office and retail, the two property types with the largest representation in the CMBS universe, face the greatest refinancing risk. About $65 billion of office loans are set to mature through 2018. A total of 7.8 percent of those loans already are at risk of not meeting the DSCR hurdle. That proportion climbs to 20.7 percent with a 200 bps increase in rates.
The wall of CMBS loan maturities has shrunk, but remains significant. Widening bond spreads have translated to higher costs for borrowers in last year's second half and could remain an issue this year. Borrowers will need to consider the impact of higher interest rates and lower LTV requirements on their ability to refinance.'
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