CMBS 2.0 is still in its teenage years but continues to mature. The moody teenager overreacted in the second half of 2011 due to the European debt crisis and general uncertainty in Washington. This source of financing continues to evolve; however, it appears to be stabilizing with conduits expected to originate $33 billion in 2012. The “parents” of the teenager (the B-Piece Buyers) now have curfews and rules that require greater transparency, stricter underwriting standards, and an improved alignment of risk. While the level of scrutiny has increased, CMBS remains one of the best sources of financing where a borrower can obtain a non-recourse loan, up to 75% leverage, at a sub-5.0% interest rate.
Despite the more stringent underwriting standards, MCA has been successful in helping navigate borrowers through some of the “mood swings” that are now showing up in most CMBS loan applications.
Lenders have recently established a “swinging lock box” where they control and have direct access to the property’s operating accounts. The increased amount of control by lenders has been giving new borrowers some heartburn. A borrower may now be subject to “triggers” that give a lender the ability to stop any distribution of cash flow to the Borrower. For example, if a property falls below a previously agreed debt coverage ratio, the Lender reserves the right to sweep 100% of the net cash flow until the property achieves the debt coverage ratio.
Prior to 2007, conduit lenders would underwrite the rental escalations in leases to achieve a higher loan amount. “In-Place Income” is now the order of the day.
B-Piece Buyers also take issue when there are in-place rents that are higher than market rents and will most likely write down above-market rents. In addition, lease rollovers have now gained the attention of lenders who will now require either an upfront leasing escrow at the closing table or establish a “trigger” to begin sweeping cash flows prior to the rollover.
In the past, a Borrower was typically asked to provide a simple financial statement along with a credit check, and that was the extent of the credit items required. In today’s environment, all lenders will require an extensive amount of credit due diligence, even if the loan is non-recourse. Be prepared to provide actual bank statements to verify liquidity, an up-to-date global cash flow, or real estate owned schedule and a summary of any contingent liabilities.
Rates, Terms and Underwriting
Conduit lenders have limited the number of Interest-Only loans as existing loans have recently begun to amortize while their respective value has declined. An interest-only loan may be obtained with lower leverage (i.e. below 65% LTV).
Lenders are now quoting terms with higher amortization for properties that have an older vintage (prior to 1980). Lenders feel more comfortable in mitigating replacement cost issues by increasing the principle paid during the term.
Debt Yields are now a very important metric used by conduit lenders. A Debt Yield (NOI / Loan Amount) gives the lender a more consistent picture, rather than applying DSCR ratios that have a low interest rate or changing amortization. Standard Debt Yields are typically 250-350 bps higher than the current cap rate. Most conduits require a 10-12% Debt Yield.
For shopping center underwriting, lenders are now performing more thorough lease abstracts and require all tenants to provide estoppels. Major tenants are now asked to provide sales figures generated at the property (should be a provision in the lease). Lenders will also evaluate the credit-worthiness of each major tenant. Tenant Improvement reserves, tax/insurance escrows, and cap-ex reserves are now mandatory for any conduit loan. Co-tenancy rights and “go dark” provisions are also receiving more attention.
Due to the number of discounted payoffs and note purchases, the cost basis has become an important issue to conduit lenders. Lenders on all levels still like to see “skin in the game” and prefer to not issue a loan higher than the cost basis or finance 100% of a discounted note, even if the value is higher.
Properties that are still in lease-up or in transition pose challenges for conduit lenders. Even if an owner has recently leased up the property, the conduit lender wants to see six (6) to twelve (12) months of stabilized expenses as variable expenses and taxes will increase due to higher occupancy. This is specifically true for office buildings that do not collect NNN.
2012 and Beyond
While some of the changes in CMBS 2.0 may seem more draconian, conduit lenders are offering non-recourse loans up to 75% LTV. Lenders are working with borrowers to create loan documents that try to incorporate more flexible language regarding the property’s business strategy and plan. While B-piece buyers have become more prudent in underwriting, there is still an increased demand for CMBS notes. The low-yield environment has made the CMBS notes a viable investment vehicle and relatively attractive compared to other investments. The increased regulations, moderate leverage, and increased transparency have allowed investors to become more comfortable with CMBS.
Rates between conduit and portfolio loans are relatively tight, between 35 and 50 bps; however, conduit lenders are offering higher leverage. Portfolio lenders are offering 65% leverage while conduits are going as high as 75% with non-recourse. Due to record-low interest rates, portfolio lenders are implementing interest rate floors to hedge against interest rate risk and to ensure a clear exit, thus allowing conduit lenders to compete.
Portfolio lenders are going for larger, Class-A properties located in major markets. Conduits have demonstrated a willingness to enter secondary and tertiary markets if the property has demonstrated stable cash flows with long-term tenants. CMBS reaches into two-thirds of the MSA’s around the country while portfolio lenders limit themselves to the top 25 MSA’s. Conduits will also finance older vintage properties; however, all funds related to deferred maintenance and capital improvements will be escrowed at the closing table.
MCA has close relationships with a variety of conduit lenders and understands the needs and risk appetites of all the active CMBS players. Commercial real estate will experience a flood of maturing loans of approximately one (1) trillion over the next three (3) years. With the huge equity gap due to the drop in valuations, borrowers are having trouble paying off the outstanding loan balance. A conduit loan may or may not be the best option under these circumstances, in which case MCA has a myriad of lenders who specialize in “gap financing” if indeed there is a shortfall from the loan offered by a conduit lender versus your required payoff amount.
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