Every day brings a new forecast: from catastrophic to worrisomely reassuring. But there’s little doubt that commercial real estate (CRE) is facing significant challenges – mainly around capital stacks and the impending refinance jam.
We’ve become accustomed to high leverage as a staple, but it has become a growing concern. We find ourselves standing at the crossroads where the consequences of yesteryear’s norms are catching up with us.
Let’s explore the challenges our sector is facing and examine their impact on the capital stack.
The moving parts
1. Interest rates
The Federal Reserve’s gradual tightening of monetary policy and inflationary pressures have contributed to mounting interest rates.
As CRE owners face refinancing, higher rates translate into higher borrowing costs, reducing cash flow and potentially straining property operations.
2. High leverage: A double-edged sword
High leverage, while tempting for investors seeking maximum returns, carries inherent risks.
In the past, easy access to credit allowed for aggressive borrowing, resulting in properties being financed with significant debt. This approach brought short-term gains but overlooked the long-term implications.
3. The refinance jam
The effects of high leverage are making themselves felt, particularly through the looming refinance jam. The combination of maturing loans and higher interest rates puts CRE owners in a tight spot.
On the one hand, they face the need to refinance their debt, while on the other, they may encounter challenges due to diminished property values, stricter lending standards, and rising rates.
4. Property values
The consequences of high leverage are evident in property valuations. The excessive debt burden suppresses property values as potential buyers become cautious about acquiring overleveraged assets.
This situation adds downward pressure to property prices, affecting both investors and lenders.
5. Lending standards
Lenders, having learned from the past financial crisis, have become more risk-averse. They are adopting stricter lending standards, including lower loan-to-value ratios and increased scrutiny of borrower financials.
This cautious approach aims to safeguard against potential defaults, but it poses challenges for CRE owners seeking refinancing options.
What the Data is Saying
Let’s back our claims with some stats. According to a recent report by Marcus & Millichap, approximately 25% of CRE loans originated between 2015 and 2017 will mature within the next three years.
This impending wave of refinancing coincides with rising interest rates, brewing a perfect storm for owners who overleveraged their properties.
Furthermore, an analysis by Trepp reveals that nearly 40% of outstanding CRE loans have a loan-to-value ratio exceeding 75%.
These properties, particularly those with declining valuations, may struggle to secure refinancing under the new lending landscape.
Embrace (for Safe Sailing)
It’s time for the commercial real estate industry to take a step back, reassess its strategies and prepare for the challenges ahead.
The real estate community needs to be proactive in addressing the capital stack imbalances and the potential consequences of high leverage.
To mitigate the refinance jam, CRE owners must explore alternative financing options, focus on reducing debt burdens and consider capital injections through equity or subordinate debt.
Additionally, open dialogue between lenders, borrowers, and regulators can foster a more sustainable and resilient CRE market.
How is this accomplished? Consider the following thoughts when planning your future recapitalization options:
1. Supplemental agency loans
If you have a good loan in place, fixed low interest rate, and plenty of term left, consider adding supplemental financing with the agencies to free up some low-to-medium cost equity. This cash could be used to bolster another refinance where you potentially are short on proceeds due to rates today.
2. Consider capital injections from private debt
A capital call (or personal equity injection) is expensive and for the life of the deal, diluting the capital stack. Consider raising capital from a private debt fund for a short term to weather the storm. Expect to pay 8% – 12% for this capital, but it can normally be cashed out in 1-3 years.
3. Open dialogue with lenders
Start planning and talking EARLY. Note that most lenders and institutions have learned lessons from the Great Recession, meaning they are likely more apt to restructure or extend the loan rather than call a loan due. Be collaborative and remember, they are not your adversary (in most cases) – they are your biggest investor.
Remember, it’s better to plan ahead than to scramble when the storm hits. By acknowledging the real issues with the capital stack
