While a majority of America is keenly aware of the housing bubble, and at least somewhat familiar with the unraveling of the European Markets, little energy is being focused on what may very well be the nation’s next looming fiscal crisis: the large volume of commercial real estate debt maturing over the next seven years.
According to Trepp, a provider of CMBS analytics and data to the securities and investment management industry, there will be more than $2 trillion of commercial real estate loans maturing by 2017. It’s estimated that half of them are “underwater.” This of course means that fully $1 trillion in commercial real estate loans will mature without a clear refinancing strategy. These loans will not be refinanceable at existing debt levels, due to a decrease in underlying asset value, and today’s lending standards are much tighter than those of the middle 2000s, which further compounds the problem.
The lenders holding these overvalued loans will seek to either (1) right-size the loan balance at maturity through a large equity injection by the borrower (if an extension is even entertained), (2) foreclose on the loan and sell the underlying collateral, or (3) sell the loans at the maximum price attainable (oftentimes at a discount to the par value). In each of these resolutions, there will be significant opportunity for borrowers and third-party buyers alike to purchase real estate or real estate debt at significant discounts to legacy value.
This massive deleveraging of commercial real estate not only creates valuable buying and restructuring opportunities, it also highlights an even larger underlying problem: Who is going to be the capital provider for these fast-moving and non-traditional real estate transactions?
All-Too Common Scenarios
A commercial real estate developer that financed a retail project in 2005 today finds that the property is now worth less than the face value of the debt owed on the asset. Tenants have left the property, rents have fallen from peak pricing, and though new tenants are seeking to lease the space at lower rental rates, there is a need for capital to pay for tenant improvements and leasing commissions. To add to the complexity of the situation, perhaps the existing lender has recently called a maturity default and is not willing to offer any extension or forbearance options. Since this loan may be non-recourse, and currently not covering debt service payments, there is little incentive for the borrower to make interest payments out of pocket or inject a large amount of fresh capital into the project to “right-size” the loan and find a new conventional lender.
In the above scenario, there are several different potential outcomes for the asset, and several pitfalls with conventional financing for each:
1. The original lender forecloses on the asset and sells to a new owner: A new operator sees this as a value investment, but few lenders are willing to lend on an asset that is being operated by a bank or receiver, and is underperforming, and will not cover debt service upon the inception of a new loan. Therefore, only cash buyers can purchase the now distressed asset. Constraining the buying pool to this group reduces asset pricing, and therefore the bank’s ultimate recovery.
2. The bank offers the borrower a discounted payoff on an existing loan. In this situation, it is very difficult for a borrower to find a new lender to provide the capital to pay off the legacy lender, both because the payoff opportunity is likely only available for a short period of time and because there is institutional reluctance among banks and traditional lenders to replace what is viewed as a competitor’s problem.
3. The bank sells the loan at a discount. Lenders may take this approach to achieve a quicker resolution than they might get through foreclosure and sale, to potentially preserve a banking relationship with a customer, or simply to get the bad loan quickly off the balance sheet. It also allows the legacy lender the ability to avoid the moral hazard of providing the existing “bad” borrower a discounted payoff opportunity.
Traditional real estate lenders—banks, conduits, and insurance companies—are simply not able to provide the responsiveness and creativity that these scenarios often demand. Typical 60-90+ day closing timelines, extensive third-party appraisals and multiple layers of management often negate any potential financing before a loan application is even submitted. Accelerated and reliable deal execution is almost completely non-existent in this new lending landscape, and yet it is the most important factor in managing the tremendous overhang of legacy debt.
Where to Turn?
Commercial real estate bridge capital sources—nimble and capable debt and equity providers—are stepping up to fill the void that conventional lenders can’t and won’t. Niche capital sources will indeed welcome the opportunity to provide the borrower necessary proceeds for a short period of time to re-stabilize the asset, and ultimately refinance it at an appropriate debt level.
Such a partner can:
1. Provide the debt necessary for the operator to quickly purchase and re-stabilize the property so that it will be more financeable in the traditional real estate debt markets.
2. Seek out these value opportunities and can provide the capital necessary to allow the borrower to take advantage of a discounted payoff opportunity. The borrower would use the lender’s proceeds for a short period of time to re-stabilize the asset, and ultimately refinance at an appropriate debt level with a traditional real estate lender.
3. Facilitate opportunities for a new value-seeking borrower to purchase a property that a traditional lending source may not want to lend on, particularly if it has been neglected by the prior owner.
4. Acquire notes to manage, service and work out, potentially in partnership with the original borrower.
To Make Matters Worse?
Compounding this problem can be issues of deal size and geography. Transitional situations are more typical for loan and property sizes under $10 million—too small for larger institutional investors to take interest in. Furthermore, coastal money tends to focus on the coastal markets, often ignoring underserved areas needing these types of solutions and relief, such as Nashville, Dallas, Phoenix, Detroit, Houston, Charlotte, Cleveland, Tampa, and Atlanta. Some examples of transitional financing successes:
— One instance is a 312-unit apartment complex in Dallas, a property that was originally acquired in 2006 for $14 million and financed with $10 million in debt. The deterioration of real estate values in 2008 resulted in the property becoming overleveraged. This, along with the borrower’s expectation that it would lose the property, resulted in reduced investment and focus on the asset.
Ultimately, in the interest of avoiding a lengthy and costly foreclosure, receivership and liquidation process, the lender offered the borrower a discounted payoff of the loan for $5 million, or 50% of the legacy debt amount. But the payoff would have to occur within three weeks.
Fortunately, this borrower was able to secure a $5.2 million mortgage loan in this time-compressed situation. The recapitalized balance sheet and additional term allowed the borrowers to reinvest time and capital in the asset. The borrowers stabilized the property and ultimately refinanced the bridge loan within 13 months.
— Another interesting success story is a 300-unit hotel located in Lexington, KY. The property was one of the last non-franchised assets owned by a major flag operator and was being acquired by an experienced hotel operator planning to reposition the hotel under a new flag. Traditional financing for this transaction was unavailable because it involved a complicated ground lease, brand transition and a short time frame to close. Closer examination revealed a backlog of room bookings, projected event-based market factors, and low loan-to-replacement value.
The operator was able to secure a 12-month, $4.9 million loan that gave the borrowers time to transition the brand, stabilize the asset, and refinance into long-term debt with an SBA loan.
— In Memphis, the operator of a 150-unit apartment building had borrowed $4.4 million against the property in 1999 and eventually lost it to foreclosure in 2009. The prior lender took the property back as real estate-owned (REO) in September 2009 and sold it in May of 2010 to a new investor that needed financing. The new owner acquired the property for $2.9 million and invested $700,000 in acquisition equity in addition to escrowing $550,000 for capital improvements.
A bridge loan of $2.2 million was used to finance the transaction. This loan represented a 50 percent discount to legacy debt, and less than $15,000 per unit. This creative loan gave the borrower time to make capital improvements to the asset and stabilize the occupancy; it was eventually refinanced by a $3.6 million Fannie Mae loan.
For brokers, borrowers and lenders alike, the lessons are these:
1. Don’t assume. There is a danger in assuming the banks are freely lending again…and equal folly in assuming that there are no capital providers looking to invest in opportunistic situations. Do your homework and evaluate all options.
2. Understand your position and desired outcomes. If you are a property owner, do you want to retain the asset and create value, but feel like you’re in a no-win situation with your current debt situation? Determine what your true endgame is—it’s often not default—and find the solution that will achieve it.
3. Time is of the essence. Know your time horizons. If traditional lending sources are not going to be an option for you to restructure your debt, it’s better to know that as early as possible so that you can start making plans B and C.
4. Deal with trusted partners. The dynamic financing markets, coupled with the great need for capital, and the promises of new and lucrative opportunities have given rise to a lot of new names and players promising solutions that they cannot deliver. Do your homework, get references, and make sure you are dealing with capitalized partners that have a verifiable track record of honest and responsive business practice.
Ultimately, the chief lesson is this: We must recognize the reality and severity of the times that lie before us. The over-leveraging of over-valued properties pre-2008 will not be solved by organic value growth, increasing rental revenue, inflation or otherwise. The near-term expiration of nearly $1 trillion in legacy debt will require a broad-based deleveraging, and the entire universe of players in the commercial real estate market—from borrowers to lenders and brokers—need to work in concert to develop creative, flexible solutions for the spectrum of property owners throughout the country that will need them.
Nicholas Coburn is the founder and co-managing partner of Bloomfield Capital, a Birmingham, Mich.-based specialty finance firm focused on originating and purchasing commercial real estate loans. For more information, visit www.bloomfieldcapital.com.