The danger is that the current high interest rate environment will make refinancing the loans on devalued properties difficult and expensive, resulting in waves of defaults and more pain for everyone involved. A lot of numbers have been bandied about concerning the volume of loan maturities, but according to the Mortgage Bankers Association (MBA), of the $4.6 trillion in existing commercial real estate loans, about $2.6 trillion will mature in the next four years.

This issue became real in February 2023 when Canadian real estate conglomerate Brookfield walked way from $784 million in loans connected to two office towers in downtown Los Angeles. At the time, media outlets reported that Brookfield had made it clear months earlier that it might not be able to refinance debt obligations on the properties. Brookfield was described as a bellwether for where the office market was headed — and it wasn’t alone. That same month, Columbia Property Trust defaulted on about $1.7 billion in debt tied to seven major properties.

The defaults by two high-profile landlords helped to solidify a sense of foreboding, which has continued to this day. In this issue of Scotsman Guide, in fact, author Rob Finlay writes about the refinancing problem (“Scale the Wall of Maturities” on Page 30) and discusses what mortgage originators can do to help mitigate the impact.

What’s unclear is how large this massive wave of refinancing needs will be. Yes, the default rate is up and there have been a few high-profile cases, but the disaster has yet to hit commercial real estate on a wide scale. Is it possible it won’t?

Jamie Woodwell, the MBA’s vice president of research and economics, explains that there are aspects of this problem that industry watchers need to keep in mind. This includes the fact that loan maturities are spread over a long period of time, in a wide variety of industries and in every geographic location, so the results will be as varied as the properties in question.

Other factors may help to lessen some of the damage, or at least spread it out. For instance, Woodwell found that of the $4.6 trillion in commercial real estate debt, nearly $2 trillion is for multifamily properties, a relatively strong sector with typically longer loan terms than other asset classes. Less than 10% of multifamily debt was set to mature in 2023, but there will be more in later years. For instance, about 16% of current multifamily debt will be due in 2032 when the economy is bound to look much different than today.

Woodwell remembers when the MBA began creating its lending survey during the global financial crisis of the late 2000s. There were worries then, too, about a wall of maturities combined with limited capital availability.

“One of the key takeaways that we found then, that I think continues to be true today, is that commercial mortgages tend to be a relatively long-lived asset,” Woodwell says. “You have an awful lot of loan types out there and, among them, commercial mortgages tend to be longer in nature. So, even now in the peak of 2023, with the greatest volume of maturities in our survey, it’s still only 16% of the total outstanding balance.”

Inflation was also reported to be falling quickly at the end of 2023 and Federal Reserve members have said that rate cuts are in the offing. Such a move would greatly lessen the sting of refinancing.

That’s not to say that commercial real estate isn’t stressed. Property values have cratered, with Capital Economics recently estimating that overall commercial real estate values fell 11% in 2023 alone and are expected to shed another 10% this year. The office sector, alone is expected to lose another 20% in 2024.

Woodwell says there’s a great deal of uncertainty about where property values stand. But it’s clear that delinquencies are on the rise. Woodwell points out that, through the first 10 months of last year, delinquencies rose in all asset classes, with the office delinquency rate exceeding those of hospitality and retail for the first time since the onset of the COVID-19 pandemic. “We are seeing stress in the market,” Woodwell says. “Pretty much every capital source has reported an increase in delinquency rates.”

One sector that may do better than expected is retail. Capital Economics expects retail valuations to increase by 6% per year through 2028. Plenty of retail sites remain under stress, but Chris Angelone, the co-leader of JLL’s national retail group, believes that poorly run operations have already been flushed out, so the owners now in place at the better-performing malls are often the best operators. Lenders would be loathe to take back those properties when quality operators are already in place.

“I think, generally speaking, that lenders are going to work with their borrowers on performing assets,” Angelone says. “But obviously, the valuations are going to be much different than before.” ●

The post Will the market avoid the worst of the looming refinance crisis? appeared first on Scotsman Guide.

“The wall of maturities represents a critical crossroads for the commercial mortgage market, impacting both borrowers and originators.”

This impending wall of maturities has far-reaching implications that will disrupt the financial landscape. It will potentially lead to a shortage of financing options, an increase in defaults and a decline in commercial property prices. While this problem is serious, there are strategies that commercial mortgage brokers and borrowers can employ to mitigate the cash-flow and financing challenges that lie ahead.

Looming crisis

This phenomenon of maturing loans within a concentrated time frame arises for several reasons. Key factors include a surge of originations during the low interest rate environment of the early 2010s, a tendency among borrowers to lock in favorable rates with longer maturities, and the cyclical nature of the commercial real estate market.

As a result, these loans are now reaching maturity simultaneously, coinciding with a period of higher interest rates and economic uncertainty brought about by hawkish monetary policy. The wall of maturities represents a critical crossroads for the commercial mortgage market, impacting both borrowers and originators.

With so much market turbulence, looming defaults and few deals transacting, one of the most significant concerns is the valuation gap. Lenders are minimizing proceeds and prospective buyers are seeking discounts for asking prices.

There is little middle ground for borrowers to account for debt-service-coverage ratio stresses, leading to reduced loan-to-value ratios and a potential decline in commercial real estate prices. Morgan Stanley estimates that commercial property values could plummet by as much as 40% from their recent peak, which would have a cascading effect on the industry.

Lender reaction

It’s important to note that the impact of these maturities are likely to vary depending on the type of asset. For example, office properties are expected to be hit harder than industrial or multifamily properties.

Responding to the rising default risks, banks are setting aside substantial provisions for loan losses. This approach could make them more cautious about lending money in the future, creating tighter lending conditions. Even the government-sponsored enterprises, Fannie Mae and Freddie Mac, are likely to be impacted, which will further complicate the refinancing of loans.

In response to the increased risk of default, lenders may impose higher spreads on interest rates and become stricter with underwriting requirements. This will restrict leverage and make it more challenging for borrowers to meet the necessary criteria, potentially exacerbating the financing crunch.

For borrowers, current loans with impending maturities also raise concerns regarding stresses tied to increased escrow and cash-reserve costs. As financing becomes scarcer and more expensive, the strain on borrower cash flow and liquidity adds another layer of complexity to the situation.

Mitigate challenges

Mitigating the cash-flow and financing challenges posed by these impending maturities requires a multifaceted approach. Mortgage brokers should communicate openly with borrowers and offer advice to help them successfully navigate the financial risks while also reducing risk to the lender.

First, consider cash-flow management. Borrowers have begun deferring payments and distributions to investors and equity holders to preserve cash, making it easier to meet other financial obligations. Additionally, selling noncore assets (such as vacant properties or underperforming assets) can help raise necessary funds.

Next is asset optimization. To enhance the value of their properties, borrowers must continually evaluate benchmark data for their respective markets. Making capital improvements to properties can increase their values and make them more attractive to potential lenders. Offering competitive rents, strategic marketing and exceptional customer service can further fortify a property’s position in the market.

The third is debt optimization. The dramatic shift in interest rates calls for a fresh approach to debt optimization. Instead of maximizing loan amounts at low rates, borrowers must focus on minimizing new infusions of equity and limiting capital calls to investors. With today’s higher-for-longer rate environment, as well as general uncertainty for both the short and long term of the yield curve, being proactive is essential as continued rate volatility will keep borrowers on their toes.

Running sensitivity analyses based on the forward curve can help borrowers assess their options effectively. If feasible, borrowers should consider fixed-rate loans with shorter terms or cash infusions to buy down interest rates. If permissible, they can seek to extend terms with their existing lender. The latter approach should be tailored to the loan type and lender, with borrowers presenting a compelling case to justify the extension.

Take action

The key to navigating the situation is proactive planning and preparation. Borrowers and brokers should start taking action now to prepare for the impending challenges. Here are a few steps they can take.

• Seek rescue capital. In some cases, borrowers may need to secure rescue capital or new equity investors. This infusion of funds can help address financial shortfalls and provide a lifeline to properties that face financing challenges.
• Plan and prepare. The impending wall of maturities will arrive swiftly, so planning and preparation are critical for borrowers and brokers. As lenders and servicers grapple with increasingly imminent extension and modification requests, maintaining open lines of communication and demonstrating consistent effort will be essential.
• Be realistic. It is crucial to have a realistic outlook on the future of an asset and the owner’s sources of funds. Loan extensions, discounted payoffs and principal paydown options may not be readily available without a well-thought-out plan.
• Stay informed. With attractive loan options limited, mortgage originators should keep clients informed about terms and rates. Defeasance consultants and third-party specialists in debt markets, hedging and interest rate derivatives can help clients create individualized strategies that take their personal circumstances and risk tolerance into account.

● ● ●

These oncoming maturities are a critical challenge facing commercial mortgage originators and their clients. The potential consequences, from a drop in commercial property prices to a reduction in lending options, are severe and should not be taken lightly. But with proactive planning and the adoption of effective strategies, mortgage brokers can help borrowers mitigate the risks and emerge from this challenging period with their financial stability intact. ●

The post Scale the Wall of Maturities appeared first on Scotsman Guide.

“Since extending the current loan is likely the solution in so many situations, it is important that brokers understand how lenders and servicers are handling these cases.”

The current freeze in commercial mortgage activity has been ongoing for much of 2023 and sales transactions have dropped precipitously. According to a recent forecast from the Mortgage Bankers Association, commercial and multifamily mortgage lending is expected to fall to a total of $504 billion this year, down 38% from the total of $816 billion in 2022. In many cases, property owners who can afford to wait are choosing to do just that in hopes that interest rates will fall in the future.

Looming problem

A major problem may be looming in the future, however, as more than $1 trillion in commercial real estate loans will be maturing in the next few years. Mortgage brokers with clients who have maturing loans secured by office buildings or apartment complexes don’t have the luxury to sit and wait. Property owners are going to be forced to refinance at rates that are twice as high (or even higher) than their current loan, depending on the lender and the location.

Even the largest players are feeling the market effects. S&P Global Ratings announced this past October that it was putting Brookfield Property Partners on a negative watchlist, meaning that the Canadian real estate giant might be downgraded to junk status. Bisnow reported that the reason for the move is Brookfield’s large amount of maturing debt amid high interest rates and downward pressure on property values.

Brookfield isn’t alone. All borrowers are facing limited options. Refinancing is going to be difficult as lending for office buildings this year has slowed and nearly halted. And the sales options (assuming the value of an office property is more than the loan amount) are also limited as borrowers will be required to put a lot more cash into the deal. So, their only other option is to get the lender to extend the loan.

The property owners who have maturing loans secured by multifamily housing also don’t have the choice to sit and wait. Just like office owners, their options are limited. While there is an abundance of debt available in the multifamily sector, the interest rate on a new loan will, once again, be much higher than that of the current loan.

The loan-to-value (LTV) ratio will also be much lower for a new loan. Some lenders are now offering loans with maximum LTVs of 50%, which means that the borrower will likely need to use a significant amount of cash to pay off the existing loan. Luckily, there’s a durable market for multifamily transactions, so these properties can often be sold. The final option is to get the lender to extend the loan.

Extension issues

Since an extension is the likely solution in many situations, it’s important for commercial mortgage brokers to understand how lenders and servicers are handling these cases. First, brokers need to explain to borrowers that lenders have an advantage when they know that owners are desperate for an extension and have few other options. Lenders smell blood in the water. After all, what else is a borrower going to do but accept the term a lender is willing to give them?

Unfortunately, even when borrowers have good relationships with lenders, they’ll find this to be the case. Everyone working with commercial real estate is ultimately in the business of making money. When they see good opportunities to turn a profit, they go for it, so there is no faulting a lender or servicer for doing the same thing even when it may not feel fair to the borrower.

This appears to be what’s happening these days. It’s no secret that an owner’s options are limited, so they’ll usually have to accept the lender’s terms. Many borrowers wind up with two options: accept an expensive offer to extend or find a private lender, often known as a hard money lender, to refinance. In essence, the current lender is the lender of last resort.

Other borrowers, however, may qualify for other creative methods, such as a high-rate bridge loan, or they could sell the property. Although some of these options may be more expensive than the offer from their existing lender, they are still worth considering. The broker needs to emphasize to the client that the best thing they can do is keep all options open and approach the lender in plenty of time to pivot to the best solution.

● ● ●

The lucky owners in 2023 may be those who didn’t have their mortgage mature. The owners in trouble today — and for a few years to come — are those who will see their loans come due. Unlike COVID-19, there are no vaccines for maturing loans. The best advice that commercial mortgage brokers can offer clients who face loan maturity issues is to plan ahead.

Brokers need to advise clients on debt issues or work with them to find the right advisers at least six months prior to the loan maturity date. Borrowers need to figure out what their options are and how their lenders are handling extensions. This information will allow them to be prepared for the process they’re about to begin. ●

The post The Refinancing Dilemma appeared first on Scotsman Guide.

These factors result in declining municipal tax revenues, forcing the local government to offer fewer services. And the decline in amenities, coupled with cutbacks in city services, forces residents to abandon downtown neighborhoods.

“Workers and corporate leaders alike are beginning to realize that sprawling offices, especially in expensive city centers, are no longer as necessary.”

While such an urban nightmare may sound unlikely, three university business professors write that there is a risk of a version of this scenario occurring. The team of Arpit Gupta at New York University and Vrinda Mittal and Stijn Van Nieuwerburgh at Columbia University have coined this scenario as the “urban doom loop,” and they detailed it in their recent paper, “Work From Home and the Office Real Estate Apocalypse.”

The urban doom loop involves a series of interconnected events that can lead to economic declines in commercial real estate and beyond. As companies reevaluate leases or withdraw from them, vacancy rates increase and landlords face challenges in securing new tenants. This results in decreased property values and potential mortgage defaults. The ensuing economic downturn affects local tax revenues, stifles consumer spending and triggers layoffs, thus creating a cycle of economic hardship.

Far-reaching consequences

The landscapes of commercial real estate and commercial mortgages are undergoing significant transformations, driven in large part by the aftermath of the COVID-19 pandemic and the accelerated adoption of remote work. The emergence of the doom loop, characterized by the potential spiral of economic challenges in commercial real estate, has economists and business experts concerned about the implications for large and midsized cities along with the financial stability of lenders.

The pandemic has led to a seismic shift in how companies view office spaces. Workers and corporate leaders alike are beginning to realize that sprawling offices, especially in expensive city centers, are no longer as necessary.

Major corporations such as Salesforce are paring back their office footprints as remote work remains attractive, leading to concerns about declining occupancy rates. This trend, coupled with reduced demand for office space, has far-reaching consequences for the commercial real estate market.

According to consulting company Buildremote, 77% of the Fortune 100 companies operate on a hybrid work schedule, while 30% of these companies have announced reductions to their office-space footprints since 2020. Also, 13% of Fortune 100 firms do not require employees to have any scheduled office visits during a given week.

These large companies have traditionally been major driving forces of downtown office usage. With these firms reducing their office-space needs and having no plans to require workers to return to the office, the first major step in the urban doom loop may be starting for many cities.

Risk factors expand

While attention has been drawn to major cities such as New York and San Francisco, midsized cities are also at risk due to their limited capacity to absorb economic shocks. Unlike metro areas with diverse economic streams, midsized cities often heavily rely on one or two key industries. Consequently, the departure of a major tenant or a decline in property values can severely impact these cities’ revenues and employment prospects.

Not every city is equally at risk. Those with a high concentration of office space but relatively little residential space are more in danger. Those that are concentrated on one industry or have a small number of employers taking up a high percentage of downtown real estate also have an increased risk because other businesses or industries are less likely to absorb excess space. Also, cities that have poor transportation options (both public and private) will have a harder time avoiding this vicious cycle.

Some cities, including Provo, Utah; Boise, Idaho; and Austin have a more resilient core given that large portions of office space are utilized by a diversified combination of government agencies, higher education facilities, private corporations and nonprofit organizations. These are also locations where residents want to live, making them less likely to join the municipalities that suffer due to an exodus from the city center.

The urban doom loop has yet to fully materialize, but warning signs are evident. Midsized cities are experiencing higher office delinquency rates and lower occupancy rates compared to larger metros. The trend could intensify as loans are due for refinancing, a situation that is anticipated to unfold over the next 12 to 24 months. The looming deadlines for commercial mortgage maturities could most acutely impact regional banks, which hold a significant portion of commercial real estate debt.

Overcoming difficulties

For commercial mortgage brokers, the path forward is somewhat opaque as interest rates have reached a point where the bid-ask spread is often too wide for buyers and sellers to close deals. Furthermore, for many properties, refinancing may not be an option as injecting more equity may not be feasible. Instead, many of these properties will be foreclosed upon by their respective lenders.

There are three areas in which commercial mortgage lenders and their broker partners can seek to weather the storm and possibly emerge even stronger. The first is to perform thorough surveillance and loss-mitigation efforts on portfolios and individual assets. By conducting stress-test scenarios at the property and portfolio levels, brokers can focus on loan workouts with many types of clients and lender partners.

The second step is to take advantage of gap equity financing programs. These are private loans that cover the gap between another loan and the total cost of a project. Whether through affiliated subsidiaries or joint-venture partnerships, lenders that continue to make market-rate loans and offer gap equity financing — also known as a bridge loan — have the highest probability of successful closings.

The third point is flexibility. Lenders and their broker colleagues who display patience, creativity and common sense on loan restructuring efforts will build plenty of goodwill with their borrowers, even after the market improves.

Conversion problems

The Federal Reserve recognizes commercial real estate as a risk to economic stability. The central bank’s recent efforts to control inflation through higher interest rates impact demand for loans and investments. In turn, this affects the broader economy and contributes to the challenges faced by the commercial real estate sector.

The decline in demand for office space is expected to impact other sectors of the commercial real estate market, such as retail, industrial and multifamily properties. Property owners are attempting to repurpose vacant offices into alternative spaces such as apartments, kitchens or spas. But such solutions are often costly and haven’t gained widespread traction. The transformation of office space is influenced by various factors, including location and property type.

Converting offices to residential buildings is expensive for a variety of reasons. For example, living spaces require natural light. The shape of an office building frequently doesn’t allow light to penetrate to an inner residence. Plumbing and electrical requirements for office buildings and apartments are also much different.

Another part of the problem is companies fleeing downtown areas. Where will these urban residents work? The number of people who live in these buildings is significantly smaller than the number of people who work in an office building. Their commercial needs are different, meaning that turning offices into apartments might not offer the same consumer support to existing retail stores.

While some commercial properties, particularly those in prime locations, may weather the storm better than others, the market is expected to see discounted rents and sales prices, especially for older assets. The repurposing of office space may also play a crucial role in determining the value and viability of other commercial properties.

This is a problem that needs creative solutions. Some answers might be found in places where office buildings are shifting to new industries rather than remaining empty. For example, insurance company Humana occupies a large amount of downtown office space in Louisville, Kentucky. When the company recently downsized, it donated one of its buildings to the University of Louisville to support the school’s Health Equity Innovation Hub. Other corporations may learn from Humana’s actions and find creative ways to reuse unwanted space.

● ● ●

Commercial real estate is in a current state of flux that is shaped by the dynamics of remote work, economic uncertainties and changing consumer behaviors. The concept of the urban doom loop underscores the interconnectedness of factors that can trigger an economic spiral in this sector and beyond.

While the worst-case scenario of declining asset values, lost jobs and failed city centers is not guaranteed, the signs are compelling enough to warrant attention from economists, policymakers and industry stakeholders. As commercial real estate navigates these challenges, innovation, adaptation and strategic planning will be needed to weather the storm and seize opportunities for revitalization and growth. ●

The post Understand the ‘Urban Doom Loop’ appeared first on Scotsman Guide.

Rising interest rates, soaring inflation and lingering fears of a recession triggered a recent banking crisis that involved collapses and government takeovers. The commercial mortgage industry was also under pressure. Capital markets pulled back, reassessed and — in some cases — almost dried up.

“The currently constrained capital market is an opportunity for sponsors to take advantage of fundraising tailwinds. Contraction among traditional lenders is also presenting debt funds with an opportunity to deploy capital.”

Borrowers had already started to seek capital for their real estate projects from a variety of new sources as more traditional sources contracted. This shift opened the door for private capital in the bridge lending space, and investors began turning to bridge lenders last year when they discovered that debt funding was unavailable elsewhere as the ultra-low interest rate environment disappeared.

As the Federal Reserve raised interest rates in 2022 to combat inflation, it pushed many borrowers into scenarios with higher mortgage costs that required larger equity commitments. On the floating-rate side, the Secured Overnight Financing Rate, which is the rate that large financial institutions pay each other for overnight loans, stood at 0.05% at the start of 2022. One year later, it stood at 4.3%, causing mortgage rates to rise dramatically while the costs of interest rate caps are up to 10 times higher. And the 10-year Treasury yield increased from 2.74% in mid-April 2022 to 3.42% a year later.

Conditions across the financial markets shifted dramatically during first-quarter 2023. This included a shift in private lending. Lines of credit were reduced or halted altogether. In fact, some well-known lenders closed shop while many others were barely functioning. General contraction occurred across the financial markets, which worked to the benefit of well-capitalized balance-sheet lenders. More time is needed for the capital markets to adjust and determine a comfortable level of activity. For now, this pause is creating opportunities for bridge lenders to fill gaps in the capital stack.

Gaining traction

Private debt, which is a loan made by a private company rather than a bank, is an investment tool that has been growing in popularity of late. This is because it provides an opportunity to invest in tangible, income-producing assets at a discount to valuation, which gives a margin of safety for pricing compression.

As loan-to-value (LTV) ratios continue to compress, capital sources with dry powder are being overwhelmed with lending requests on high-quality assets in strong growth markets. This provides a tremendous opportunity for the lenders that have adopted a creative approach with their operations. There is a large amount of private debt capital waiting for opportunities, and stronger sponsors with experience in this niche will stand out in the market.

Commercial real estate investors continue to be attracted to private debt because they can find relative certainty within a favored alternative asset class, according to a recent survey from real estate services firm CBRE. Despite economic uncertainty, debt tied to real estate (especially multifamily and industrial assets) delivered higher returns compared to other investment types. Private debt is attractive because it provides short-term, opportunistic capital amid a higher interest rate environment.

CBRE’s survey found that more investors are expected to implement opportunistic debt strategies this year compared to last year, due to the attractive returns amid higher interest rates and tighter financial market conditions. Many investors expect to see pricing discounts of 30% or more across multiple sectors, with shopping malls and value-add office assets expected to offer the greatest opportunities.

In other instances, bridge lenders come to the rescue when borrowers find the traditional loan approval process is taking too long. Rather than waiting, borrowers move to solidify their positions with a bridge loan — short-term financing that is designed for transitionary periods and helps to ensure a project moves forward in alignment with a business plan. As banks and other traditional lenders pause to reassess the market, bridge lenders are often a viable solution because they provide certainty that the sponsor’s business plan can be executed. Bridge loans also have proven useful in cases where a borrower no longer qualifies for a bank loan due to the rapidly shifting market.

Lower expectations

Market turmoil at the beginning of 2023 was cited as a factor in liquidity reductions across the commercial real estate capital markets. Caution and conservative underwriting tend to be a comfort zone for lenders. The volatility and subsequent pullback caused spreads to widen across a range of lending groups, from debt funds to banks and commercial mortgage-backed securities (CMBS). In fact, CMBS issuance was down nearly 80% year over year in Q1 2023, according to Trepp data.

An unintended consequence is that as risk increases, investors seek safer investments such as Treasury bonds. This works to drive down yields and increase prices, which can reduce losses on bond sales. For commercial mortgage borrowers, they could eventually find themselves in a more favorable interest rate situation.

This should not be a surprise. Loan activity was already decreasing at the end of 2022, and projections for this year called for commercial and multifamily mortgage lending volumes to fall by about 15%, according to the Mortgage Bankers Association. The trade group’s forecast assumed “economic weakness at the start of 2023 with a moderation in interest rates and an overall improvement in the economy as the year goes on.”

Banks experienced a record year of commercial mortgage originations in 2022, making $479 billion in loans or nearly 60% of the total origination volume among all capital sources. But these sources are pulling back and even disappearing as they assess portfolio risk and address depository requirements.

Rocky road

Borrowers who face looming loan maturities in 2023 aren’t likely to find many allies either. Trepp estimated this past March that some $448 billion in commercial mortgage debt will mature this year. Interest rate hedges must be extended at much higher costs, delinquencies are expected to rise and market participants will naturally be a bit nervous.

The year ahead will likely include a period when traditional lenders retrench. New capital looks to find a home in the market. The coming year generally looks to be a growth opportunity phase for private lenders that reserved cash and have been operating without leverage. It is expected to be a lender’s market as large banks retreat while small and midsized banks work to stabilize themselves. The recent collapses of Silicon Valley Bank and Signature Bank have stoked caution.

This environment is creating more opportunities for bridge lenders to complete deals that involve higher-quality borrowers and less risk to achieve improved returns. Yields in the high single digits to mid-teens are being realized, depending on the strategy.

Quality loan submissions are increasing while LTVs have decreased due to debt-service-coverage constraints. That said, the market is shifting, with select property types falling out of favor. That alone is a reason to move ahead with caution. Lenders that focus on senior positions and less leverage will be able to withstand a major economic event. This structure has worked well in the past and will continue to give lenders an edge while the market corrects.

Returns for debt funds are expected to exceed those achieved from 2019 to 2022. The wider margins that debt investors are experiencing across risk profiles are being realized because of capital market headwinds and the Fed’s intention to drive down inflation through higher baseline rates. Lenders have an opportunity to seize outsized returns even when lending on collateral that’s been repriced due to factors such as the expansion of capitalization rates.

Market transformations

Leverage on new loans being made today is nowhere near historic averages. This places lenders in more advantageous positions in the capital stack now compared to where they may have been following the financial crisis of 2007 to 2009. Ultimately, the risk-reward trade-off found in the current market is likely better than what lenders experience in typical cycles.

The currently constrained capital market is an opportunity for sponsors to take advantage of fundraising tailwinds. Contraction among traditional lenders is also presenting debt funds with an opportunity to deploy capital. Some lenders have extended their pipelines as interest rates have increased, largely because floating-rate lenders, debt funds and non-debt capital sources have dramatically curtailed their lending activities.

The market also has experienced a transformation among bridge lenders that were reliant on demand for floating-rate products, as well as business models that required warehouse lines or securitization in the collateralized loan obligation (CLO) market. These sources of capital have been weakened by the current market conditions.

Some bridge lenders have responded by adding new products, putting them in a better position to satisfy demand from borrowers and investors who seek lower risk profiles. Even in a higher interest rate environment, there’s an opportunity for growth.

● ● ●

Those who’ve been in the commercial mortgage industry for more than a decade understand that markets change and adaptations to these changes are required for survival. They also know that, amid the darkness, hope remains and opportunity exists.

Time will tell if the stress being felt across the banking industry results in decreased commercial mortgage activity for the balance of the year. It is a legitimate concern, especially since regional and midsized banks hold crucial roles across the entire banking system and account for much of the capital for commercial real estate loans. To mitigate pain, borrowers will need to explore options they may not have previously considered. One of these avenues will likely lead them down the path to a bridge loan. ●

The post Bridge Over Troubled Waters appeared first on Scotsman Guide.

To get his take on the market, Scotsman Guide caught up with Kraut recently while he was on a visit to the Dallas-Fort Worth area. He’s been a skeptic of the fast-paced growth in apartment complexes and says it was apparent that one of the capitals of the Sun Belt growth movement was beginning to see some stumbling blocks.

“That’s going to be an interesting situation where the rubber meets the road. How many people have the money to resize their loans?”

– Joel Kraut, co-founder and managing director, BRRRR Loans

Like many major cities, the Dallas area has been building multifamily properties as fast as possible to meet the growing population demands. It is estimated that between 2010 and 2019, nearly 687,000 people moved to the Dallas-Fort Worth-Arlington metro area. But even with that growth, Kraut says apartment rentals are slowing down and landlords are beginning to have trouble renting at the prices they need to make the cost of these new buildings pencil out.

“They aren’t breaking price on rent, but instead are giving one month free or two months free for a 12-month lease, so it doesn’t affect their continuous rental (income),” he says.

This may seem like a small thing — a mere blip on the screen that will pass next season — but it links to much larger problems that loom on the horizon for commercial real estate. The latest wall of worry for the mortgage finance industry to climb is a major refinancing risk that is coming. But this potential new crisis is not in the office sector, which has its own seemingly endless set of woes. This refinance problem is in the once bulletproof multifamily sector.

The recent regional banking crisis has raised worries about the commercial real estate sector’s ability to refinance maturing loans. Data provider Trepp reported this past April that an estimated $940 billion in multifamily loans are set to mature in the next five years, with banks accounting for $344 billion of this total. Trepp notes that the only other commercial property type with more bank loan maturities during the same period is office, which is expected to face approximately $400 billion in maturities. Across securitized debt, a total of about $82 billion in multifamily loans are scheduled to mature this year and next.

Although multifamily has done very well in recent years, many developments were financed during a low interest rate climate. Even then, many developers were counting on rents and property values to keep rising in order to cover the costs of refinancing.

But if apartment rents slow or decline, and properties lose value, then developers may find themselves squeezed while trying to refinance debt deals that no longer makes financial sense. A few casualties have already appeared, including Applesway Investment Group, which lost four Houston apartment complexes to foreclosure in April. According to The Wall Street Journal, most of the company’s loans to buy the properties were originated in the second half of 2021, just before the Federal Reserve began raising rates. At least two of the properties were financed with about 80% debt while the interest rate on at least one loan rose from 3.4% to 8%.

This type of problem is certainly more of a worry in the office sector, where the market has already seen a number of high-profile properties go into foreclosure as borrowers walked away, either unable or unwilling to make loan payments. But it could become more common for apartments if the rental market continues to cool down.

Real estate analytics firm Green Street estimates that apartment values have dropped by more than 20% from their recent peak. At the same time, rent appreciation is slowing. Apartments.com reports that rents increased 2.5% year over year in first-quarter 2023, down from 3.8% annualized growth in the prior quarter. The company also reported that more than 1 million units were under construction at that time, with supply likely outpacing demand. Each of these factors seem to lead to a market that is about to put the squeeze on borrowers seeking a refinance.

“I think you are going to see a lot of foreclosures,” Kraut says. “As rates reset on some existing newer properties and the groups that raised the money for those properties come back to make deals two years later, they will find things have changed dramatically and the math doesn’t add up.”

Kraut doesn’t expect the foreclosures to be a major crisis for the mortgage industry. But he does think that the next 24 months may present an opportunity for certain lenders willing to fund deals. With debt-service-coverage ratios and debt yields on these loans being difficult to support, many owners and operators will be forced to bring fresh capital to the table to reset their loans.

“That’s going to be an interesting situation where the rubber meets the road,” Kraut says. “How many people have the money to resize their loans? Some clearly will — but not a lot.” ●

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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. ●

The post A High-Wire Act appeared first on Scotsman Guide.

While home values will likely continue to increase, consumer spending power is decreasing in the face of inflation and higher interest rates. In response to inflation, Federal Reserve rate hikes have previously meant higher mortgage rates, in turn making home equity financing options more expensive.

“Home equity investments aren’t as well known, but they can be an innovative choice for clients who don’t want to or can’t afford to take on debt to access their equity.”

These circumstances mean that your clients might need to spend a bit more time figuring out the best choice for themselves. Historically, the most popular forms of equity-based financing are home equity loans, home equity lines of credit (HELOCs) and cash-out refinances.

A newer and less well-known product, the home equity investment, has also emerged as a viable option. Before diving deeper into the details of home equity investments, let’s review the traditional equity-based lending solutions. In terms of the general economic climate and your client’s financial profile, there are advantages and disadvantages to consider for each option.

Traditional products

With home equity loans, which feature fixed interest rates, homeowners can receive a lump sum of cash to pay for home renovations or repairs, or to pay off other bills. To qualify for these loans, homeowners need sufficient income, a good credit score and 2% to 5% of the loan amount for closing costs.

Home equity lines of credit allow homeowners to pull from an approved amount of equity as needed. Like home equity loans, HELOCs require good credit and have minimum income requirements. But they come with variable interest rates, meaning that monthly payments can fluctuate. And if the borrower’s home value decreases, the lender can freeze the HELOC.

As of March 2023, interest rates for home equity loans and HELOCs range from 6% to 10%, and they may increase further if federal rate hikes continue. In both cases, the home is used as collateral, so the loan balance is repaid via monthly installments.

With a cash-out refinance, homeowners replace their original mortgage with one for a larger amount and pocket the difference to pay for expenses. Although interest rates for cash-out refis are typically lower compared to home equity loans or HELOCs, the closing costs can be more expensive.

Home equity investments

Home equity investments aren’t as well known, but they can be an innovative choice for clients who don’t want to or can’t afford to take on debt to access their equity. With this option, homeowners receive cash upfront in exchange for a share of their home’s future value.

Qualification requirements are often less stringent than with traditional financing choices. And there aren’t any monthly payments or accrued interest — just an appraisal fee, an origination fee and other closing costs. There’s also no income verification, which can make this an appealing option for self-employed workers and those without customary W-2 income.

The term lasts anywhere from 10 to 30 years. The homeowner can buy out the investment at any time with savings, by refinancing or through the proceeds of a home sale. Home equity investments can be more expensive than traditional types of products, however, with the investor receiving their initial payout plus a significant percentage of any future increase in home value (often 25% or more).

Like traditional equity products, home equity investments don’t come with any restrictions. Some homeowners put the money toward starting or expanding a business, paying down debt, covering a child’s education or diversifying their portfolio. And there are plenty of other ways for homeowners to use the proceeds from a home equity investment.

• Second homes. Home equity investments can cover the downpayment and closing costs for a vacation home.
• Home renovations. Home equity investments can pay for renovations or repairs that boost a home’s value prior to sale.
• Bridge loan alternative. Bridge loans give borrowers fast cash so they can buy another home before selling their current property, but they come with high interest rates and fees. While a home equity investment can take as little as a few weeks to close — longer than the bridge loan timeline of a few days — it can be a smart alternative for people looking to buy their next home.
• Real estate investing. Investment properties can present great opportunities for portfolio diversification and passive income, but the downpayments, closing costs, and ongoing expenses such as insurance and repairs can add up. Home equity investments can help cover the expenses needed to get started.

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Mortgage originators who add home equity investments to their portfolio of solutions can help themselves and their clients in a number of ways. Not only can it help you distinguish yourself by providing an innovative product that most financial institutions don’t offer, it can also allow clients to pay off debts, enjoy more financial freedom and build future homeownership opportunities.

Since the home equity investment model is still relatively unknown, introducing homeowners to this option increases awareness and education of the product while enabling them to make informed decisions about the many equity-based financing solutions. Traditional equity loan options have become less accessible and less ideal in today’s higher inflation and higher interest rate climate. With home equity investments, your clients can still benefit from tapping into their equity without the stress of monthly payments or upfront debt. ●

The post There’s Another Path to Consider appeared first on Scotsman Guide.

As the use of private money has expanded over the past decade, newly formed companies came to the table to meet the needs of this growing sector. Fast forward to 2020 when the COVID-19 pandemic hit. To counteract the effects of the ensuing economic crisis, federal monetary policies perpetuated an unchecked buildup of liquidity in the markets due to COVID relief funds. The Federal Reserve lowered benchmark interest rates to near zero. And private lenders backed by large hedge funds accessed sizable low-rate credit lines.

“Typically, title insurance is mandated by banking regulators and it is a requirement if the loan is sold to investors on the secondary market.”

Aggressive standards

Eager to deploy historically low-cost capital into higher-yield loans, lenders pushed billions of dollars into the market via lenient lending standards and higher leverage ratios. Conventional lenders still needed to adhere to federally regulated lending practices, but private money was not bound by these same statutes.

There was more money in the system than there were sensible deals that required private capital. Hence, the industry adopted more lenient underwriting standards. Private lenders pushing higher leverage allowed more money to be moved.

The result was that many individuals borrowed beyond their carrying capacity and properties were leveraged beyond traditionally cautious private money underwriting standards. Loans were created that would have been previously unrealized and aggressive lending practices created little margin for error. These new “volume-focused” lending practices required a continual increase in asset prices to be sustainable.

Enter the market shift. The Fed has pivoted to reduce inflationary pressures by increasing the prime interest rate. Money that was deployed at low interest rates is now creating a strain for credit line-based lenders whose capital costs have significantly increased.

As borrowing costs for consumers and businesses have increased, asset prices have declined to match the reduced purchasing power. The individuals and businesses that took out high-leverage, short-term loans at yesterday’s low interest rates are finding that extension options are not readily available. This is due in part to leveraged private lenders that don’t have the capacity to extend.

Return to normalcy

Today’s lenders are requiring significant cash to be brought to closing to make the numbers work in the current reality. Existing loan structures often do not meet stricter underwriting practices and valuations.

Here is an example. In January 2022, an individual obtained a 12-month loan with an 80% loan-to-value ratio on a rental home in a major West Coast city from a private lender that obtains financing from an East Coast-based hedge fund. The loan had an attractive rate and required only a 20% downpayment. The deal allowed the borrower to purchase the property at a cost of $1 million.

Fast forward to January 2023. The balloon payment was due and the private lender was unable to extend the 12-month term. The lender’s hands were tied because its source of capital needed the cash back immediately.

In pursuing alternatives, the borrower sought private lenders with stable sources of capital. The conundrum was that the borrower obtained a loan of $800,000 on a property that by 2023 was worth $800,000 in the current market. The most plausible option available on a short-term bridge loan was 70% of the current property value at a considerably higher rate than before. This equated to a $560,000 loan with the client needing to bring $240,000 to closing.

This scenario is one of many that is manifesting daily. It is the reality of 2023. Lending practices will continue to be more prudent and durable during this market correction. Cautious underwriting practices that governed private money in the previous decades are coming back. Over time, this will lead to a more stable and consistent private lending environment. And this transition will create numerous opportunities for commercial mortgage brokers and entrepreneurs. 

Saving balloons

In the coming months there will be a meaningful number of loans with balloon payments that will require action to stave off becoming distressed assets. Mortgage brokers may find it fruitful to focus on finding short-term loans that are maturing. Many of these loans can be broken down into two scenarios.

The first is one where the borrower becomes overleveraged and needs to liquidate their holdings. This will bring opportunity for a savvy entrepreneur to purchase an asset at a favorable price. In turn, it will offer a new business opportunity for a mortgage broker to work with a bank or a private lender on the origination of a new loan.

The second scenario involves a borrower who can rightsize the loan through cash and collateral, allowing new funding to be executed. In these cases, creative private lenders can find solutions to cross-collateralize and originate a loan.

In both scenarios, mortgage brokers can build durable, long-term relationships with new clients, offering value and practical help to resolve a tough situation. Finding solutions for clients in these predicaments will help to build a brand and reputation that will outlast the current lending cycle.

Borrowers can save their investments and eventually complete a sale on their own terms. Many believe that interest rates will stabilize and potentially improve this year. Historically, asset values have bounced back and increased over the long term.

New opportunities

These scenarios illustrate opportunities for brokers to expand their businesses at a time when loan origination activity is scarce. With the rise of short-term loans in the past few years, maturing loans will be coming down the pipeline and borrowers will need professional guidance.

When seeking short-term solutions from private money lenders, be sure to practice due diligence. Brokers and borrowers should investigate private lenders and know the answers to certain questions, such as:

• What is the lender’s source of capital?
• Do they have discretionary control over their funds?
• How long have they been in business?
• Do they retain and service their loans or sell them upon closing?

As the market continues to shift, it is imperative that commercial mortgage brokers and borrowers work together to find solutions to everyone’s benefit. The current year will bring about many challenges mixed with many opportunities. Transactional volume will likely remain lower for the foreseeable future, but there will always be potential business for brokers and entrepreneurs who understand the market and seek funding the right way. ●

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The real estate analytics company’s newest Mortgage Monitor report revealed that, as things currently stand, the pool of potential refi borrowers is extremely shallow.

“With interest rates now at their highest level in 20 years, the refi market is rapidly approaching a bottom,” said Scott Happ, president of Black Knight division Optimal Blue. “Indeed, our most recent Mortgage Monitor report showed that the number of borrowers with rate incentive to refinance has hit an all-time low of around 130,000, and the vast majority of those are at least 14 years into a 30-year mortgage, with little incentive to restart the clock.”

The dearth of potential borrowers helped push overall rate-lock dollar volume down 14.3% month over month in October. At the end of October, this volume was at its lowest level since February 2019, precipitated in large part by a 25.1% plummet in cash-out refi locks. Cash-out loans had shown some buoyancy even in the face of the rapidly rising rate environment, largely due to tappable equity nearing record highs early in 2022. But this resilience has faded and cash-outs were down 83.6% year over year in October.

Rate-and-term refis, meanwhile, have continued to slide, dropping by additional 15.7% last month. They’re now down an astounding 92.6% from October 2021, and refinance locks of all types comprised only 14% of all activity in October 2022.

On the other side of the market, purchase lending also continues to slide as the slowing of home price growth has been generally offset by rising interest rates. The dollar volume of purchase loan locks fell by 13% monthly and by 39% yearly in October.

“Affordability remains the overarching concern in the mortgage origination market right now,” Happ said. “Despite home prices continuing to pull back in a growing number of markets across the country, the current rate environment means affordability remains a thorny challenge.

“It’s therefore not very surprising to see a resurgence of somewhat lower-rate loan products like ARMs (adjustable-rate mortgages),” he added. “Affordability, rates and home values all factor into falling purchase prices and loan sizes, and all are generating headwinds over and above the normal seasonal downturn.”

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