When it comes to the commercial real estate financing market, 2007 has not been a year for the faint of heart, nor for those uncomfortable with change. Indeed, this year has provided us with some rather dramatic developments related to self-storage interest-rate spreads and loan-program terms.
However, self-storage owners and investors should not despair. To borrow a phrase from Bob Dylan, the times they are a-changin, but there are still plenty of opportunities to secure favorable loan terms for your acquisition or refinancing. To do so, youll need to recognize and adapt to the new market landscape, adjust the approaches you may have previously taken when obtaining financing, and develop new strategies to capitalize on these market modifications.
A Scary View
This year, the credit markets have been fascinatingeven a little scaryto watch as the so called credit crunch took center stage with significant market volatility. In dramatic fashion, the Federal Reserve finally intervened in August by slashing the discount rate 50 basis points, effectively reassuring markets that it was willing to take the necessary steps to keep the financial system solvent and functioning.
Although its often difficult to pinpoint the specific causes of any capital-market disruption, the reasons for this years commercial-mortgage market volatility are fairly straightforward. The capital markets are experiencing turmoil created by a loss of confidence from bond buyers, resulting in a fundamental, market-wide re-pricing of risk. Its genesis was investor troubles in residential sub-prime mortgages, which led to a capital-markets downturn and investor lack of confidence. The problems compounded and culminated in a re-pricing of credit risk that extended well beyond the residential sub-prime sector.
Unbeknownst to most property owners and commercial borrowers, the first evidence of this market re-pricing appeared in April 2007 when Moodys Investors Service released a white paper stating that lax underwriting on commercial mortgage backed securities (CMBS) loans had increased investors risk. The rating agency vowed to increase subordination levels on future CMBS transactions. Other rating agencies followed suit, and the net effect was an increase in the cost of capital to CMBS lenders as bondholders required a higher yield investment return.
CMBS and other capital-markets lenders reacted to these announcements quickly by tightening underwriting standards, scaling back or eliminating interest-only loan periods, scrutinizing the real estate fundamentals, and boosting equity requirements all of which effectively reduced available loan proceeds to borrowers. Over the next several months, the so-called credit crunch took center stage as sub-prime woes continued and other market sectors became infected by the turmoil.
A manifestation of these changes in the CMBS markets is buyers of the riskiest collateral classes, known as B-piece buyers, are demanding higher yields. They have effectively retreated from the market and stopped purchasing the currently available CMBS investments.
Lenders, however, have continued to make loans in this now uncertain environment by attempting to price in the new yield requirements necessary to spur investor appetite. Loans are stacking up on lenders books, and with no buyers in the market, inefficiency has emerged between the supply and demand sides of the equation, thus furthering pricing uncertainty.
Currently, there are billions of dollars in commercial mortgages lenders have originated and closed that still are working through the system and being sold via CMBS bond placements. This scenario is further complicated by the fact that many of these same market participants rely on collateralized debt obligations (CDO) placements on Wall Street to create liquidity. CDOs, however, are currently facing a similar fate as CMBS investments, creating a vicious cycle that has yet to resolve itself.
There is a strong likelihood that capital markets will remain volatile until lenders sell their existing CMBS loan inventories and the CDO market stabilizes. It is also highly unlikely that lenders and investors will ever resume the same aggressive pricing levels that were so prevalent prior to this years major market event. What you will probably see is a move toward more historically normalized, risk-adjusted capital returns, resulting in a stabilized increase of commercial mortgage spreads by as much as 75 to 125 basis points in the CMBS market.
In the face of such rampant volatility, there is really no way for a borrower to be fully insulated from these market changes. However, you can take steps to protect your investment and ensure a loan transaction accomplishes your financial goals and meets your borrowing requirements.
Understanding Your Lending Options
Self-storage owners need to understand their lending options as they venture forth into this new financial landscape. As a starting point for your financing strategy, take time to research and understand how lending programs have changed and adjusted to capital-market volatility in the past year. And be sure to ask plenty of questions so you fully recognize your loan obligations.
Here are some things you can expect in the new lending environment:
- CMBS lenders have quickly reacted to market conditions with higher spreads. By late August, interest rate spreads for long-term, fixed-rate self-storage deals were trading in the 200-plus range over the 10-year Treasury. Dramatically more conservative underwriting standards are now being applied as well.
- Life-insurance companies have also increased their spreads, although not as significantly. They primarily set interest rates based on corporate bond yields, which have risen in this market. In addition, they buy AAA CMBS bonds. Expect life-company loans to be priced slightly less than CMBS options and to encounter more conservative underwriting standards here as well.
- Commercial banks have not yet been fully affected by the credit imbalance and are actively seeking to place commercial loans. However, larger banks likely have CMBS exposure, either through their origination networks or as investors in CMBS bonds. This may cause them to re-evaluate their lending requirements and could impact a self-storage deal.
- Bridge and mezzanine markets are also somewhat unsettled. Lenders with limited credit lines have withdrawn from the market, and its likely that most bridge and mezzanine loans will increase rates over previously quoted deals by .25 percent to .50 percent. The amount of leverage being offered to property owners will most likely also decrease.
Establishing Realistic Expectations
If you think you can relive the glory days of highly aggressive loan terms and generous underwriting standards, you need to recognize the realities of 2007. Those days are gone and not likely to return.
Underwriting standards tightened dramatically this year. For each loan request, lenders are taking a harder look at property fundamentals, market vacancies, historical property performance and market competition. Debt service coverage ratios should be expected at the minimum level of 1.20x. Interest-only periods will be limited to two or three years, and may not be available at all depending on the transaction. Lenders are no longer eager to waive reserves to win business, and are more closely evaluating a property owners experience and past performance in the loan-application process.
You should also recognize that competitive lending terms might become even more limited before the end of the year. It will be more difficult to shop a deal and compare apples to apples. Some CMBS lenders have already retreated to the sidelines and stopped issuing quotes because they cannot assess their profitability.
As part of your strategy, adjust the way you analyze lender options. You cant look at them the same way you did before this market correction. Your selection criteria should be driven more by a lenders ability to deliver the deal rather than an evaluation of the cheapest or best available terms.
Its also important that you understand the MAC (Material Adverse Change) clause in the loan application. Most CMBS lenders will issue quotes but will predicate a MAC clause in the application. This allows the lender to modify spread or loan terms based on current market conditions, which may be materially different than when the application was executed.
Many CMBS originators have exercised the MAC clause in this volatile market, in some cases, even after the interest-rate spreads were locked. This is clearly within the legal parameters of loan applications and commitments, but it has left borrowers exposed to changes in loan dollars and interest-rate levels. If youre in the market to refinance or acquire a self-storage property, be extremely cautious of application terms and work with your lender or mortgage broker to find ways to decrease your risk.
Changin for Good
Indeed, self-storage financing has changed in 2007. Property owners, who grew comfortable in the past six years or so with highly leveraged financing options and generous interest-only loan periods, will encounter a dramatically different lending landscape.
Whats important to remember is the markets have not shut down. Transactions are still being secured and closed, and you can still obtain financing for your properties. But the alteration in the markets will force you to re-address your financing strategy. By understanding these changes, recognizing we are not returning to pre-credit-crunch market conditions, and conducting due diligence, youll find you can still obtain a highly competitive loan product that is priced at historically favorable rates.
Shawn Hill is a senior vice president with Beacon Realty Capital, a Chicago-based commercial real estate financing firm that specializes in supporting self-storage owners nationwide with their financing needs. He can be reached at 312.207.8237 or [email protected].