The Shift in Concern as 2022 Comes to an End
It’s definitely not a dull time to be working in the capital markets arena. With interest rates rising we’re seeing investors slowing down. But when volatility in the debt markets increases, it makes our jobs more valuable to our clients as we’re able to act as consultants for their portfolios.
Lender Tightening Recap
My colleague, Chris Peters, and I wrote a piece last month on lender tightening. This is not Fed tightening, but it’s the terms, conditions, and criteria that lenders (primarily banks) use to issue loans. And those criteria and terms have been on the rise again in 2022. If you look at a graph of lender tightening versus easing, it has literally been a roller coaster ever since the beginning of 2020, starting with Covid. Lender tightening peaked in Q3 of 2020; PPP money flooded the market, housing shortages became the main focus, and the need for more logistics and general goods increased the price of industrial real estate. Easing came rushing in until the beginning of 2022 when Chairman Powell stated that the good times were over and we needed to start addressing the threat of inflation and a potential recession. Landlords (and lenders) became concerned with the value of their current buildings and if the newly increased rent revenue that they were seeing would be sustainable. As a result, we saw an increase in lender tightening yet again. Getting into Q4 of 2022, we’re still continuing to see lender tightening; but we see a new concern that is different than the previous worries about CRE value, rents, and recession.
A New Concern…
We have a new theme when it comes to the concerns of landlords, developers, investors, and lenders, and it has to do with loans coming due in the next 12 months. The loans I’m referring to can be both construction loans and conventional 5-year term commercial loans. In the construction space, we saw ground-up development deals being modeled out 2-3 years ago that had stabilized NOI projections that would allow for permanent agency financing at a high leverage point. Now, because of how high rates have climbed, that NOI does not cover the debt service at a sufficient level. When we’re talking about Fannie Mae, we typically need a 1.25x DCR. I work with a fund where they had a $43mm development that is now fully stabilized. The development group hit their NOI projections and the asset looks beautiful and didn’t go over budget. However, pre development, the lender penciled the deal to be a high leverage takeout from an agency lender. Now, the debt service is much higher because of higher rates, and the NOI can’t cover it at a 1.25x level. They need to lower the leverage and now the developer has to inject millions of equity into the deal, potentially diluting his limited partners. A situation where we try and get creative with bridge or mezzanine financing.
In some rare cases, you see it with standard refinances. If you look at the 5-year treasury 5 years ago, as of right now, it was around 2%. If you look at it 4 years ago, as of right now, it was around the 3% mark. Over the last few months, it’s jumped substantially. Last week, we maxed out around 4.45% and it’s come down since putting us closer to 4.15%. Regardless, we have another 75 BP hike from the Fed next week that swaps, and trading desks have priced into the market. Any more or less will significantly affect equity and bond markets. With these hikes, banks and credit unions’ cost of capital have increased substantially. I had the opportunity to speak on a panel last week and gave this exact example.... Let's say we had a $10 million acquisition in 2018. At the time you could get that financed at rates below 4% and at 80% LTV (loan-to-value). You had to underwrite that to a 1.20x or 1.25x debt coverage ratio (DCR). i.e. Your NOI over debt service. Depending on if you had a 25 or 30 year amortization, it would have affected how quickly you would gain more equity and pay more principal off in the property. If it was written with a 5-year term, then by the end of the 5-year term coming up in 2023, you will have paid off anywhere from $800k-$1mm in principal. Here’s where the issue comes in. Now, we have anywhere from $7.0-7.25mm in principal. The bank will now underwrite that same deal, but now we’re at rates over 6%. If you take $7.2mm and amortize it over 30 years with that huge jump in interest rates, you won’t be able to make the new DCR work. We went from 1.20x DCR with an $8mm principal (at 3.75%) down to a 1.02x DCR with a $7.2mm principal (at 6.15%). Banks will not approve this deal to move forward. What if there were rent increases over the last 5 years? Yes, it’s very probable. If an industrial property had 2% YoY increases, it still would be hovering around 1.12X and the deal will not pass a bank’s credit committee. In order to make this deal work at 1.20x DCR, with the newly increased market rates, the principal balance would have to come down $7.2mm all the way to $6.7mm. That means that the investor would have to put in another $500,000 of cash into the deal just to make the refinance work with his or her previous bank lender. This reality is a nasty wake-up call for some investors about what’s really going on in the markets and how it flows through to them
Anything to Do?
We’ve been speaking to some debt funds in our network (we work with over 300 debt funds across the country), that are starting to see an increase in deal flow for refinances. This is because in some scenarios, a debt fund can make the deal work as they often don’t have to abide by strict guidelines and are able to lower their DCR requirements. So, just maybe, in some scenarios, they can be okay with an interest-only loan for 24 months at a higher interest rate and it may only underwrite to a 1.05x or 1.10x DCR, but they’re okay with it. However, they’re not really underwriting it for the current DCR; what they’re really doing is projecting interest rates in 24 months, and then asking themselves, “will a bank make a refinance with this loan at a DCR of 1.20x with the current principal?”. If it passes that test, they’ll make a bridge loan and the investor will not have to put that large $500,000 of cash to make the deal work. It doesn't always work like that, but it can. We’re seeing these situations, analyzing them, and executing on them.
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