The CMBS Tsunami

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Will It Bring Opportunity Or Devastation To Facility Owners?

Commercial real estate sits in the midst of a potential wipeout wave of debt that is coming due in 2016 and 2017, which could spell disaster or perhaps opportunity for some building owners. It all depends on the financial health of the owners and their properties.

Real estate professionals have been bracing for a wave of maturing commercial mortgage-backed securities (CMBS) estimated to exceed $300 billion over a three-year period that began in 2015. CMBS maturities in self-storage are expected to reach just south of $6 billion over that period.

Like a tsunami that emanates from a distant earthquake or other geological event, the current wave of obligation was created a decade ago during a frenzied building period when boatloads of borrowers found CMBS debt an attractive way to finance new construction.

CMBS issuance was the highest from 2005 to 2007, a period that was characterized by aggressive credit underwriting with high loan-to-value (LTV) ratios and low debt service coverage ratios (DSCR), according to Transwestern, a real estate firm based in San Francisco.

While CMBS debt can be issued with five- or seven-year terms, the majority of the loans were made for 10 years. There has been great concern that this impending flood of CMBS maturities will result in widespread defaults if properties fail to recover value lost during the downturn and borrowers are unable to contribute the extra equity needed to satisfy lenders’ stricter LTV requirements.

With an estimated volume of $2.4 billion of CMBS debt in self-storage properties this year and another $1.7 billion in 2017, will owners be able to refinance and maintain their businesses, or will we see a number of distressed sales in the upcoming two years?

Conversely, many owners who refinance properties that have stabilized and gained value in recent years could find themselves awash with millions of dollars in cash-out proceeds. This windfall cash could be the catalyst that puts hundreds of new storage projects on the drawing boards in the coming years.

Financing The Bubble Years

More than $300 billion of commercial real estate was financed with CMBS during the real estate bubble years of 2005 and 2007, according to Trepp, a provider of analytics and technology to the financial and commercial real estate industries.

“It was a time where lenders were very aggressive,” recalls Tom Sherlock, principal of Talonvest Capital, Inc., in Irvine, Calif. “Interest-only periods were prevalent; leverage was prevalent; and lenders were willing to move up the leverage curve.”

The major concern about the surge of refinancing coming due is that, based on current interest rates, about 6.4 percent of maturing loans would not meet the minimum refinancing requirement of a DSCR. Moreover, if rates climb 150 basis points, the percentage of outstanding loans that would not meet the minimum DSCR rises to 15.7 percent, according to Trepp.

“In some cases, those properties still have loan-to-value ratios that are too high and debt service coverage ratios that are still too low,” Sherlock notes. “The good thing for the storage industry is it wasn’t hit as hard by the economic downturn as office and retail. Those property types are likely to experience a greater preponderance of loans that won’t be conventionally refinanced.”

Of the total commercial real estate financed through CMBS, self-storage represents only about two percent of the loans issued. An estimated $5.9 billion of CMBS loans made on nearly 1,300 self-storage properties are coming due over the three-year period, Trepp says.

“Some of that has been proactively prepaid and refinanced already because rates have been so low and capital has been readily available,” says Shawn Hill, principal of The BSC Group in Chicago.

Key Elements Of Refinance

Neal Gussis, a principal at Des Plaines, Ill.-based CCM Commercial Mortgage, identified the ideal candidate for refinancing a CMBS loan. “Anybody that hasn’t refinanced in the last two to three years who has the ability to refinance with a limiting prepayment penalty, this is a great opportunity to take advantage of rates and aggressive financing before any upward trending of interest rates.”

For owners looking to refinance their loans with new CMBS debt, cash flow is king. Lenders will examine the trailing 12 months of operating performance to assess the stability of the asset.

“CMBS lenders are primarily focused on the resiliency of the cash flow going forward, which is needed to repay the loan and eventually the bondholders,” Hill says. “If a property has CMBS debt on it now, it’s easier to go back to the lender and show the property has 10 years of cash flow,” Hill says. “It’s documented so lenders can clearly see the history of the property.”

Hill adds that lenders are more focused on borrower quality than in the past, so they will study the facility operator and their level of storage experience and management ability. Also, the markets where the properties are located warrant scrutiny.

Sherlock sees three positives working in the favor of CMBS borrowers. “There’s a growing supply of available capital,” he says. “CMBS lenders, national and regional banks, life companies, and credit unions all are interested in financing self-storage properties. The second positive trend over the last five years has been an overall easing of credit standards. And third, operational trends for occupancy, revenue, and NOI growth have been positive for a number of years.”

Another element that helps most storage owners today is the escalating values of their properties in recent years. “Those folks who have those loans coming due are very fortunate,” says Dean Jernigan, CEO of Memphis-based Jernigan Capital. “As late as two years ago the market hadn’t come back to any great degree and those properties were still underperforming for the most part. Although rates were low, their NOI [net operating income] was not that good. If they had been managing their property well for the last two years, they have their NOIs in good shape.”

CMBS Refinancing Benefits

CMBS refinancing has several advantages for eligible owners. CMBS offers a lower fixed rate and is non-recourse, so the borrower typically has no personal guarantees. If cash flow is a concern, CMBS sometimes gives borrowers initial years of interest-only payments with a favorable amortization schedule. CMBS will most likely allow the borrower to cash out on refinancing, allowing the real estate owner to deploy proceeds for other investments.

While CMBS lenders generally prefer transactions that exceed $3 million, there are more than 40 CMBS lenders on the street, and all have different appetites for property type and loan size.

“Think of it like Baskin Robbins, there’s just about a flavor for everybody,” Hill says. “There are lenders that will be willing to do tough deals. Most of the time on a $3 million or $4 million deal, unless it’s a property that’s had a very challenged history, you can usually find a lender that will do the deal. The question is at what price?”

CMBS does have a downside. “The price they pay is they’re going to be locked into stringent prepayment penalties or defeasance, which doesn’t allow them to easily pay off the loan until maturity,” Gussis says. “If they want more flexibility and not be tied to a loan with a prepayment penalty, then they’ll likely want to go to a source other than CMBS.”

Self-storage has attracted numerous new financing sources in recent years, so alternatives are available for owners who can’t refinance into CMBS, or simply don’t want to. “If you don’t like the pricing the CMBS market wants to give you, your options would be banks or credit unions, which are typically recourse lenders,” Hill says. “Those lenders are relying heavily on the strength of the guarantor or sponsor, so they may be willing to absorb a property that they perceive to have more risk based on the sheer strength of the sponsor.”

Life insurance companies are also active in storage; however, they generally prefer larger and lower leverage transactions. If a deal is turned down by the CMBS market, then it’s unlikely the insurance companies would pursue it.

Focus On Attractive Properties

Everyone wants to meet the most attractive person at the dance, and lenders are no different. Owners of Class-A facilities in metro areas with good cash flow, enviable NOIs, and high occupancies have their dance cards full. Some borrowers in secondary, tertiary, or rural areas, however, may have issues refinancing their loans.

“CMBS lenders do not like to lend to thin markets—say populations of less than 50,000 within five miles of the property,” Hill says. “For example, a CMBS lender is certainly not going to make a $3.5 million loan on a 100,000-square-foot facility in a town of 10,000 people. Anything tertiary or rural is likely not a great fit for CMBS.”

But with so much new money entering the storage sector these days, there may still be options available for everyone. “Clearly, Class-A facilities generally in larger loans have benefited from better interest rates and more financing sources available to them,” Gussis notes. “However, there are still plenty of financing options available for properties in secondary and tertiary locations. The CMBS market is still very accepting of secondary and tertiary markets. The most limiting factor for self-storage for CMBS lenders is the loan dollars. If you get much below $2 million, the population of CMBS lenders willing to provide financing goes down significantly.”

Positive Storage Metrics

It appears that many owners of retail and office buildings may have difficulty refinancing their CMBS loans over the next two years. But storage is a different animal, and the metrics have been positive for several years running. Yet, the CMBS tsunami probably will take out some facilities in its wake.

“Those positive operating trends should make refinancing the 2016/2017 maturing CMBS loans easier,” Sherlock predicts. “While we may feel some limited impact of maturing CMBS loans, the greater impact on the industry was the maturing construction loans made when we were closer to the apex of the recession. We don’t anticipate many problems refinancing permanent loans that were made in 2005, ’06, ‘07, although tertiary market financings may have some difficulties.”

Default rates for storage facilities have been low historically, and, coupled with the industry’s positive economic trends, it’s hard to find an expert predicting dire straits for owners.

“I have a hard time believing there are a lot of broken self-storage CMBS deals maturing in the next two years,” Hill says. “With storage I think it tends to happen more with a facility coming out of development that has leased up slower than expected or missing the local bank’s target stipulations. But the overall metrics of the industry are so strong, and you have so many factors working in your favor currently, that I believe properties that are coming out of 10-year maturity that are distressed now would have some critical flaw. This means either the real estate is broken, the management is broken, or both.”

Gussis adds, “I don’t see a lack of financing being the reason for an owner to sell a property. The decision to sell is more lifecycle oriented or the ability to compete at a smaller level.”

Cash-Outs May Spur Building

What is more likely to occur during the CMBS wave is an escalation of new building as a result of the cash-outs storage owners will take during refinancing. These cash-outs could result in facility expansions or remodels or even new development.

“If the property has increased in value significantly over the term of the existing loan, the sponsor could be looking at a windfall of equity recapture that they can redeploy into additional investments or distribute to their partners,” Hill says. “Investors could potentially use the money to expand or enhance their existing properties, or alternatively they can buy or build a new property. For the real estate investor, capital is very a powerful tool.”

Jernigan’s firm has clients who have completed cash-outs from CMBS refinancing and used that capital to develop new properties. “That is a wise use of that capital if they know how to develop storage,” Jernigan says.

“It’s an incredible source of equity,” says Gussis. “That’s cheap equity because they’re not having to go to friends and family or other investors to raise that capital and borrow at significantly higher rates. The industry is very compelling and if you have the ability to grow, most investors want to take advantage of that.”

While many property owners have taken advantage of cash-outs, Sherlock has seen some lenders become more cautious because of the trend. When some lenders structure and price loans, they are examining the amount of cash equity the owner has remaining in the property after refinancing.

“Is there a big cash-out refinance or is there still cash invested by the owner in the property?” Sherlock asks. “We are seeing lenders getting more conservative on those loans. Some lenders are pricing them higher. Some lenders are mandating stricter terms, for example less interest-only when there’s a full cash-out.”

Rate Hike, Regulatory Fears

Following the Federal Reserve Bank’s first rate hike in a decade in December, economists are forecasting increasing Treasury yields in 2016 and a rising rate environment for possibly the next few years. Meanwhile, CMBS rates were setting their own pace in 2015, rising from the low four percent mark early in the year to nearly five percent by year-end. The two components that make up the borrower rate, the Treasury index and credit spread, continue to widen.

“If you combine increasing Treasury and swap yields with widening credit spreads, we could be heading into over five percent rates,” Sherlock warns. “The expectation from a lot of lenders is that rates will be higher as we get further into 2016.”

In addition, some financial experts fear that new regulatory mandates on CMBS lenders will drive up loan rates further. CMBS borrowers with maturities after 2016 may have to choose between the lesser of two evils: Should they take the penalty hit for refinancing their CMBS loans early to avoid higher rates in the future or wait it out and hope for the best at the time of maturity?

It is helpful to note that even with rising interest rates, they are coming out of historical lows. Sherlock points out that the 10-year Treasury rate today is approximately 2.25 percent. In 2006, it was 4.42 percent.

“Even though rates are much higher than one year ago, sometimes we forget 10 years ago and five years ago that rates were higher than they are today,” Sherlock says.

Owners who are looking at refinancing in 2016 or 2017 should consider consulting with a financial expert or mortgage broker with a self-storage specialty to help navigate this tricky refinancing process and avoid drowning in details. A second set of eyes will help to analyze the borrower’s costs, prepayment penalties, and defeasance to determine the best time to refinance a CMBS loan.

Facility owners facing a maturing CMBS loan down the road should take a close look at their financials now. Lenders use a trailing 12-month income report to evaluate the property, so now is the time to implement rent increases to make cash flow as robust as possible. Clean up any questionable expenses and address delinquencies, late fees, and concessions.

A strong balance sheet is likely the best way to withstand the impact of an unpredictable CMBS tsunami.

David Lucas is a freelance writer and editor based in Phoenix, Arizona. He is a regular contributor to all of MiniCo’s publications.

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