The drop in interest rates has been great news for borrowers, with low cost of capital that is effectively giving them more buying power. Yet, for the most part, lenders are keeping borrowers in check on leverage and structuring deals with an eye on an easy exit at maturity.
Lenders learned some hard lessons in the last recession that are now being put to work to mitigate future refinancing risk. “We’re nowhere near the same place that we were back before the Great Financial Crisis,” says Tom Genetti, a managing director at capital services provider Berkadia. “I think the discipline being shown in the marketplace today is substantially higher. There is real equity in these deals, and no one is allowed to put in fluff or big fees to make their (equity) look bigger than it should be.”
There’s a lot of data that goes into refinance tests, and that data definitely helps the lender get comfortable with the refi risk coming out in the future, adds Jeffrey Erxleben, executive vice president, regional managing director with NorthMarq in Dallas. The guiding principal these days is underwriting a long-term loan at a debt service coverage ratio (DSCR) of 1.25x. Depending on the asset and underlying economics in terms of purchase price and valuation, that 1.25x usually covers leverage on the top end at 75 percent loan-to-value (LTV) and 60-65 percent for coastal assets, Erxleben notes. “I think that combination of having that cash equity, along with the supportive market data and historical performance of the markets that those long-term lenders are in, gets them comfortable with that refi test risk,” he says.
In some cases, Fannie Mae and Freddie Mac are looking at the risk profile on a deal and requiring a higher DSCR of 1.30x, adds Genetti. “So, even the agencies are looking at things a lot closer, and there is a concerted effort to make sure that deals are getting underwritten properly,” he says.
Keeping CMBS leverage in check
Fitch Ratings recently raised the question of future refinancing risk in an article that it published on Lower Interest Rates Should Not Equal More Leverage in CMBS. Fitch researchers noted that an increase in leverage in CMBS loans, leaving DSCRs at their current levels, would make the loans more susceptible to refinance risk at maturity due to the increased debt.
The focus on refi risk was likely triggered by Fitch analysis that shows loans getting done at very low rates today. Among the roughly 48,000 CMBS loans originated between 1995 and 2007 in Fitch-rated multi-borrower transactions, only 1.7 percent were originated with a mortgage rate below 5.0 percent, and only 0.3 percent had a rate below 4.5 percent. In contrast, close to 100 percent of loans in recent CMBS transactions presented to Fitch have mortgage rates below 5.0 percent and pool-wide averages are below 4.0 percent.
Effectively, nearly every loan Fitch has recently reviewed has a mortgage rate well below the historical data set used by the agency to back-test its rating criteria and rating model. Fitch noted that it is factoring in those low rates and future refi risk when stress-testing loans by using a model that blends the actual coupon with a stressed refinance coupon.
IO loans land on the hot seat
One potential wild card is how record low interest rates might increase refinancing risk specific to the growing volume of interest only (IO) CMBS loans. CMBS players have used IO loans to distinguish themselves in a highly competitive market.
“We have seen greater than 50 percent of the loans in our deals have IO as an option for the borrower,” says Geoffrey Caan, managing director, U.S. fixed income, at Sun Life Investment Management. “In one sense, you’re not amortizing down the loan. So, in 10 years it is potentially riskier as the loan-to-value on the loan—outside of any appreciation in the property—hasn’t really improved.” That being said, lenders are underwriting to IO and still maintaining a fairly conservative stance on other underwriting characteristics, he adds.
The buzz on full-term IO loans sounds awfully aggressive until you realize that the going in loan-to-value is being set at an estimated exit loan-to-value 10 years from now, says Genetti. “Lenders don’t mind giving IO, because they’re basically pre-amortizing the loan on the front end by having a de-leveraged transaction,” he notes. Lenders are also more conservative on leverage in those full-term IO loans. They are not offering 75 to 80 percent leverage on 10-year IO loans, and the more aggressive interest rates are going to be reserved for deals that are 50-65 percent levered, adds Genetti.
Even those full-term IO loans that look like they have achieved 75 percent leverage are more like 68-72 percent when you dig deeper into the underwriting economics, such as using a more conservative valuation, says Erxleben. There are always examples of outliers in the market. However, in those cases where lenders are willing to stretch out with higher leverage, it is usually because of some mitigating factor, such as the strength of the sponsor or strength of the market, he says.
Another aspect that shows that lenders are being disciplined is that there are different levels of IO in CMBS depending on the property type. Office properties have more IO loans, whereas assets that are perceived to carry more risk, such as hotels and retail, tend to have fewer IO loans being done. B-piece buyers are also providing an additional stop gap on risk by scrutinizing the quality of loans within pools. CMBS lenders are taking that to heart and not doing deals they know will likely get kicked out of the pool, notes Genetti.