Although interest rates have been rising recently, they continue to hover at some of the lowest levels in 30 years. The real estate economy remains healthy. And lenders are fiercely competing to lend their money to the right retail projects. It sounds like a good time to refinance your shopping center, particularly if capital costs continue upward.
In the shopping center industry, as in other types of real estate, the reasons to refinance are varied. The most obvious reason is to obtain cheaper capital, but other factors are just as important to some borrowers.
The property owner may want to obtain better loan terms based on improved rental rates at the center, or achieve a higher loan-to-value (LTV) ratio to gain more dollars for working capital needs. Perhaps the owner is seeking a longer amortization period. Or, more simply, and what is more common, a balloon payment is coming due and the owner is looking to work one or more of the previous options into the same deal.
"With the large amount of capital that is in the marketplace, to win deals you have to differentiate yourself from your competitors," says Fred Kurz, eastern territory manager of U.S. investments with GE Capital Real Estate, Stamford, Conn. Many firms are distinguishing themselves by offering a wide range of refinancing methods, he adds.
But as the number of refinancing options increases, so does the amount of homework the owner needs to do in order to select the proper financing vehicle and the right type of lender. Among the relevant factors are the type of property, the quality of tenants, and the length and provisions of the leases.
The answers the owner finds could point to the CMBS market, which is improving although still on the rebound from the correction suffered during the fourth quarter of 1998. Another approach is to obtain more traditional institutional financing from insurance companies, pension funds and banks, which are traditionally more conservative but usually take into account more real estate intangibles than does Wall Street.
But again, the trigger to refinancing is access to inexpensive capital. And in the current market, it is both cheap and plentiful.
A capital auction In 1992, the interest rate on 10-year Treasuries, which is used as the baseline for determining mortgage interest rates, averaged approximately 7%. Today, it is approximately 5.75%, says Dan Bryson, senior director and producer, for Houston-based lending intermediary Holliday, Fenoglio, Fowler.
Although 5.75% is still low, 10-year Treasury rates have risen 150 basis points since October, and more than 50 basis points since early April. The increase is among the sharpest the Treasury rate has experienced in recent years. "And that makes deals harder to get done," says Simon Ziff , president of The Ackman/Ziff Real Estate Group LLC, New York.
"The interest rates are popping around, which is disquieting to borrowers," says Rob Schneiderman, executive vice president with New York-based Parallel Capital LLC, who projects that the interest rate will continue to rise through the end of the year.
Under the circumstances, the assumption might be that borrowers would jump on current rates before they rise any higher, but the 10-year Treasury's volatile nature still has some borrowers waiting for rates to come back down again. Lenders don't advise speculating on interest rates.
"We urge our clients to look at the absolute cost of capital, and the current rates are still good deals," Bryson explains, adding that capital availability problems could arise later in the year due to lenders reaching allocation limits, or potential Y-2K problems.
The lower rates last year coupled with the very active CMBS market led to numerous refinancing deals in 1998. The result has been lower volumes this year.
"On the supply side, there is a lot of money available," says Ziff. "But on the demand side, quite a few owners have already taken the opportunity to refinance, and now there is not as much product out there."
"So much was done last year that this year is naturally a little slower," agrees Craig Johnson, director with Phoenix-based FINOVA Realty Capital. "There is a need for more projects, and to land enough deals, lenders are starting to stretch."
Lenders are offering higher LTV ratios and longer amortization periods, which means more cash up front and lower loan payments. Institutional lenders have increased their average LTV ratio from 70% to 75% with amortization periods of up to 25 years. In the CMBS market, conduits are offering LTVs of 80% with a 30-year amortization.
"The competition is driving these numbers," stresses Ziff. "We are creating an auction atmosphere for the borrowers who are accepting the most recent, best terms."
Refinancing considerations While the terms are improving in general, the owner/borrower must first determine exactly what the goals are for the property, and become aware of its present and potential earning power, to assure the real estate will qualify for the best loan terms possible.
"The borrower has to carefully think through where he wants to go with the property," says Kurz.
Is the property correctly positioned? Is it likely that more competing shopping centers will be built in the market? Are many of the center's leases near the end of their term? If so, are the current rental rates above or below current market rates? Does the owner intend to hold on to the property long term?
These questions can help the borrower determine if the property should be refinanced now or later, and offer guidance as to what type of lender he should pursue.
Prepayment penalties and yield maintenance requirements are also important factors. Prepayment penalties are designed to discourage the borrower from paying off the loan prior to the lender making a substantial profit from interest on the loans. And yield maintenance requirements serve basically the same purpose.
"Yield maintenance requirements were common in CMBS loans of seven or eight years ago," says Jim Reich, vice president with Houston-based Dana Commercial Credit.
Yield maintenance stipulations allow the borrower to prepay the loan, but requires the borrower to maintain the conduit's yield for the full term of the loan. Often, these additional costs make refinancing too expensive.
A good refinancing transaction takes more into consideration than a lower interest rate. Some owner/borrowers are looking at refinancing as a way to generate extra capital from a thriving center.
"The NOI (net operating income) of many shopping centers is increasing, and owners have become more creative," says Reich. "If they can cash out equity, they can use capital to improve the property or buy other properties."
So, if the shopping center is well-positioned in the market with regard to lease-up and sales potential, the owner is probably ready for permanent financing.
"If not, he may be better suited to sticking with the existing loan until the property's potential is maximized," advises Nancy Spokowski, vice president with Boston-based Berkshire Mortgage Finance.
Two examples of maximizing a center's potential are: renovating to attract a stronger anchor, or rolling over a substantial amount of the property's space at higher rents. But timing determines just what kind of loan is needed.
"If the property will soon experience a capital event that could drastically change the economics of the center, the owner would probably be better off waiting to refinance," explains Ziff. "The improved numbers would allow the owner/borrower to qualify for a larger loan and/or better terms."
In such an instance, the owner would probably consider the use of mezzanine or bridge financing, which is shorter-term financing provided to fund center upgrades.
These improvements allow the owner to acquire more attractive terms on permanent loans. Several firms that provide permanent refinancing loans also provide bridge financing.
"If the upside can be achieved in three years or less, the owner/borrower would be better off to borrow short term," says Ziff.
Amid the competitive environment, some lenders are using convenience as a marketing tool.
For example, GE Capital offers a program in which the borrower's bridge financing automatically rolls into permanent financing in the CMBS market. Kurz says this expedites the process and reduces the red tape involved.
Speed in processing loans is another important factor, says Kurz. "We have streamlined our process by delegating more authority to the people in the field," he says. "We can make a commitment within 30 days or less and provide the funding within 45 to 60 days."
The creditworthiness of the tenants in a retail center can also play a part in refinancing. Strong credit tenants signed to long-term leases signify stability in income stream. However, this connection is appreciated more in some circles than others.
"Portfolio lenders take more into consideration than just the numbers," says Steve Graves, senior manager with The Principal Financial Group, Des Moines, Iowa. "The tenants and their credit rating make a difference."
"Insurance companies are more concerned about the creditworthiness of retail tenants than the CMBS lenders," agrees Ziff. "Wall Street doesn't differentiate as much on the creditworthiness of the tenants."
In general, conduits base most of their underwriting strictly on the numbers: "the consistent cash-flow history of the property," says Graves.
However, notes Joe Cunningham, president of Sacramento, Calif.-based Liberty Mortgage Acceptance Corp., "underwriting is an art, not a science."
Credit tenant lease financing is a rapidly growing segment of the market. Some firms, such as New York-based Capital Lease Funding, specialize in credit tenant lease financing.
William Pollert, president and CEO of Capital Lease Funding, explains the distinction between a traditional conduit real estate loan and credit tenant lease financing: "In a credit tenant lease transaction, the lender's emphasis is on the lease and not the real estate."
The wording of the lease and the degree to which it limits the tenant's ability to terminate the lease or abate rents is the key factor. Pollert says the company's lending programs include many lease-enhancement mechanisms that can plug holes in the existing lease and make less-than- perfect leases work for a refinancing transaction.
Triple net leases, which require the tenant to essentially pay for all of the cost associated with the property, are ideal from the owner's and lender's perspectives. "These leases allow the investor to look straight to the credit of the tenant when considering the strength of the loan," Bryson explains.
Grocery-anchored centers favored In the present refinancing market, grocery-anchored neighborhood centers are the most sought-after retail properties. "That's the middle of the strike zone," emphasizes Bryson. But other selected retail concepts are attracting interest.
"Grocery-anchored centers and dominant malls are good products, but it's everything on the edge that is a problem," Graves says, insisting that the Internet is casting a shadow over other types of retail, at least in the minds of lenders.
Power center projects featuring high-quality anchors such as Wal-Mart and Target can obtain refinancing, reports Bryson. However, unanchored strip centers and all but the strongest outlet centers are not good bets.
"Major department stores have cut prices so much that there is not as much price differential as in the past," says Johnson.
Leases are another refinancing drawback to outlet centers. "While most outlet tenants are good credit tenants, they generally sign short-term leases, and if sales are not good, they close the store," explains Cunningham.
CMBS vs. institutions Most of the retail refinancing loans underwritten this year will be in the CMBS market, with totals expected in the $40 billion to $50 billion range. Life insurance companies will do about another $25 billion. Commercial banks also are expected to lend a substantial amount, though less than the other two sources.
This numerical division is determined by what each lender group is seeking. Insurance companies want less risk, and thus refinance the choice investment-grade properties.
The mortgage loan default rates for investment-grade product (BBB- and higher) is substantially lower than for non-investment grade product. Thus, on a risk-adjusted basis, loans on investment-grade properties are priced less.
"The insurance companies are looking for the higher-quality properties, and as a result they are more competitively priced for these centers," says Ziff.
However, while margins are smaller, these loans offer lower LTVs and shorter amortization periods, which forces some borrowers, seeking these more favorable terms, to look elsewhere for capital.
Below-investment-grade product goes into the CMBS market where the higher risk is reflected in wider margins. CMBS loans, in general, offer the attraction of higher LTVs and longer amortization periods. So the owner/borrower has to weigh these factors in choosing the proper lender.
"If the borrower is looking for high leverage, CMBS is the way to go," says Bryson. Insurance companies offer average LTVs of 75% compared with CMBS loans, which offer around 80%. This difference can be substantial. "On a $20 million loan, you are talking about another $1 million to play with," says Spokowski.
But other borrowers are more concerned about communication with the lender.
"I have clients that want to deal only with lenders they can continue to talk with throughout the life of the loan," says Ziff. "If there is a problem - say, the center loses an anchor - the borrower could possibly rework the loan to get money to upgrade the center and get a replacement anchor. There is more of this type of flexibility with insurance companies and pension funds than with conduits."
"Once a CMBS loan is completed, it is sold and the conduit is done with it," says J. Edward Blakey, senior vice president of commercial mortgage origination for San Francisco-based Wells Fargo.
"It's not that the conduit doesn't want to help the borrower, but it just doesn't own the loan anymore," says Graves of The Principal Financial Group.
Blakey says Wells Fargo avoids the client communication problem by serving as the master servicer of all underlying loans its CMBS bonds are issued on. As the master servicer, Wells Fargo can still work with the borrower on the loan. "That is a big distinction from most conduit lenders," he says.
Although interest rates may be on the way up, they are still very attractive to shopping center owners looking to refinance, and retail is still an attractive property type to many lenders looking to place money in real estate.
"We are bullish on shopping center properties," says Kurz. "The economy is strong, and we like where retail is on the cycle."