UPDATE – JUNE 16, 2023 – One lender contacted me and said a 300bp increase in mortgage rates has occurred. So, I wanted to update the analysis below accordingly. Most everything stays the same below. Loan amounts, Market Values, and LTVs do not change. The only items that change are the new ADS and resulting DSCR.
For Apartments/Industrial the DSCR declines from 1.3 to 1.2, which is where it was when the original loan was made. Again, I do not think this would present problems for refinancing.
For Office/Retail the DSCR declines from 1.13 to 1.05. Per below, the new LTV is 72%. So, there might be some work to do on refinancing these property types. Are the hurdles significant? I don’t think so.
Thanks to all that provided some feedback on this post.
JUNE 15, 2023 – Besides the media hanging the threat of a recession over our heads for the past year, they have jumped on the commercial real estate (CRE) loans are going to go bad by the millions and take banks down bandwagon. So far, the financial institutions I talk with have seen virtually no pain. Of course, the pundits would say, just wait, it is coming. As you probably know, I am a numbers man. So, let’s do some math. What you will see below is some property types should have no problem refinancing at the current interest rates and other property types should have a little struggle. Is there a HUGE problem out there? Per the math, I don’t see it.
APARTMENTS and INDUSTRIAL – 3+ years ago we had a property with $100,000 PGI. 5% Vacancy and 30% OER and we have an NOI of $66,500. Using common appraisal acronyms, so hopefully you know what they mean. At a 1.2 DSCR the Annual Debt Service (ADS) was $55,417. At a 4% interest rate and 20-year amortization, the Loan Amount was $762,084. At a 6% cap rate, the Market Value was $1,108,333. A 69% LTV.
In the past 3+ years, rents for these property types have increased by well over 30% in most markets. So, today we have a PGI of at least $130,000. Let’s reflect the market decline of the past year and increase vacancy to 10% (pretty crazy for these property types today) and increase the OER due to inflation increases expenses (albeit rents probably went up way more). Our current NOI is $76,050. At a 7% cap rate (rates are up about 100bp over the lows last year…might not actually be up from 3 years ago, but…we are assuming the worst-case scenario), the Market Value is $1,086,429. The original loan has been paid down to $682,750, resulting in a 63% LTV. Using a 6% interest rate (commercial rates are not up as much as residential rates) and 20-year amortization, the new ADS will be $58,697. The resulting DSCR is 1.30.
So, we are refinancing today and the LTV has declined from 69% to 63% and the DSCR has increased from 1.2 to 1.3.
I am not seeing how these borrowers, and lenders, will have any difficulty with refinancing loans that are 3-5 years old. For these property types.
OFFICE and RETAIL – I won’t bore you with the same narrative all over again. I changed the rent growth to 0% from 30%+. One could argue rents have declined for these property types. If you have evidence of such in your markets, then the scenario described here is better than you will experience. I assumed 20% Vacancy and 40% OER then and now. Those are relatively pessimistic.
The original loan was $550,073 on a Market Value of $800,000. LTV was 69%.
The outstanding loan balance is now $492,810 and the Market Value has declined to $685,714. The LTV is now 72%.
To refinance at 6% for 20 years, the new ADS will be $42,368. NOI has remained at $48,000. So, the new DSCR is 1.13.
Again, I am not seeing where the borrower or lender will have trouble refinancing this loan. If I didn’t make such negative assumptions about these property types 3 years ago (but, remember back to June 2020 and virtual all office buildings were empty and most retail stores were closed) and used a lower vacancy, it is likely the LTV increase and DSCR decrease would be a bit more. But, still not problematic.
I know the CMBS market is getting killed. However, in talking with my clients, their borrowers that own office and retail buildings have shored up the loans and there isn’t a feeling of much risk. I know for sure banks lend much different than the CMBS market.
As always, we shall see how this plays out. Note, the above is about income-producing properties. Business loans are a different story. Lots of businesses can fail and lenders take back CRE as collateral. But, the loan going bad had nothing to do with the CRE market.
Glad to receive comments as usual.
I now think I have emptied my queue of ideas to post about. As my brain never stops thinking, I am sure it will come up with something else to write about soon. All I have to do is look at media headlines and I will be triggered. lol