Let’s Talk Debt (Continued)

Hey there, Mo here 👋

Last week, we talked a lot about certain debt topics. In reality, that’s piercing the surface. Debt and capital markets (aka finding equity to fund deals) placement is a career in its own right.

Today, we’re going to be covering a few topics like:

• Loan modifications/extensions

• Debt service coverage ratio

• Conditions for refinancing

• Refi vs sell

• Interest rate management

Loan Modifications and Extensions

When commercial real estate loans near maturity and they’re unable to service debt, they have a couple of options.

This is going to be very important as loan maturities are coming due with bridge debt and valuations are dropping.

Negotiating a loan modification or extension with the existing lender can provide more favorable terms and avoid refinancing costs.

Loan modifications

Loan modifications involve actively amending the original loan contract terms. This may include reducing the interest rate, lowering monthly payments, waiving deferred interest, extending the maturity date, or even reducing principal. 

Modifications provide payment relief and let borrowers correct excessive leverage. Lenders may compromise to avoid default or foreclosure.

Loan extensions

Loan extensions simply push out the maturity date of the loan, often by 1-3 years. This allows continued operations under the original loan terms instead of facing a balloon payment.

Extensions are generally easier to obtain than full modifications if the loan is performing satisfactorily. Lenders grant extensions when continued cash flow merits maintaining the financing relationship.

The advantage of loan modifications or extensions is the ability to adjust challenging loan terms without undertaking a complex, expensive refinance.

*The current adage in the market is to “survive til 2025” when we will have a better idea if the Fed is going to hike or reduce interest rates.

Debt Service Coverage Ratio:

Debt service coverage ratio (DSCR) is a metric used by lenders and investors to measure a property’s ability to cover its mortgage payments through NOI or operating profit.

DSCR is calculated by dividing a property’s net operating income (NOI) by its annual debt service (principal + interest payments).

A DSCR of 1.0 means NOI equals debt payments – barely covering the mortgage. A higher ratio indicates more cushion to fund the debt.

Minimum DSCR requirements vary by lender but are often 1.20 to 1.25 for commercial properties. For riskier properties, they look for higher DSCR’s (aka give lower leverage) to reduce the risk of losing bank equity.

Strategies to improve DSCR and reassure lenders include raising rents to boost NOI, making extra principal pre-payments to reduce annual debt service, and refinancing high-interest debt.

Some lenders may also restructure terms if DSCR falls below requirements by extending loan terms or interest-only periods.*

*This depends on the relationship with your bank. If you’re using a CMBS lender or bridge lender, they generally will originate the loan and then sell it off as a bundle.

Prime conditions for a refinance:

A lot of syndicators who bought in 2020-2022 bought buildings on short-term, high leverage debt with the intention of refinancing.

Unfortunately, that time has changed and it might be better to sell.

The best conditions to refinance include:

• A strong credit score, ideally 720+ for commercial loans or 650+ for residential. *Mostly used in recourse debt.

• Significant equity, meaning a low loan-to-value ratio (LTV) of 70% or less. Less leverage = better (right now).

• Excellent debt service coverage ratio (DSCR) of 1.2x or higher. Refinancing cash flowing properties well in excess of mortgage dues inspires lender confidence.

• Documented stable, positive property performance including occupancy rates, rent collections, maintenance costs and profitability.

Of course, a lower interest rate is pivotal to justify refinancing costs. But lenders also emphasize creditworthiness, strong equity positions and efficient operations when evaluating refinances.

Refi vs Sell

Particularly in today’s economy, it’s hard to refinance. This leaves the obvious answer to selling.

Refinancing offers the chance to correct issues with the existing loan, like reducing payments by lowering rates. It also lets you maintain ownership rather than surrendering upside potential down the road or buy out some existing ownership.

Selling provides a clean break from headaches, even at a lower price. The capital can be redeployed into more promising assets. Transaction costs and tax implications must be modeled, but selling lets you cut your losses early on a “dog” of a property.

To decide, project the IRR over a 5-10 year hold under each scenario accounting for all costs, risks and timeframes. Most institutions assume a refinance will happen between years 2-3 after the initial value-add is done and the property has a time to season.

What is the goal of refinancing?

Will refinancing generate sufficient savings to justify added years of ownership? Or will cutting losses now via sale lead to better capital allocation elsewhere?

There’s no one-size-fits-all answer. The analysis depends on your specific circumstances. Don’t forget to include all transaction costs when you sell or refi.

Interest Rate Management

Most real estate investors use some variable rate loans like ARMs.

With these, interest rates fluctuate over time, causing your monthly payments to vary after years 1-3. This makes it hard to budget for free cash flow & when to replenish reserves.

There are financial instruments designed specifically to limit rate volatility – interest rate swaps or interest rate caps are 2 common features.

Interest Rate Caps

Interest rate caps are commonly used for protection. You pay a one-time premium to cap the maximum rate hike over a defined period, usually 5-7 years. If rates spike above the cap, your rate stays constant. Caps provide certainty by defining worst-case payment scenarios.

Interest Rate Swap

Another option is an interest rate swap. This derivatives contract exchanges your variable rate interest payments for fixed rate ones with a bank counterparty. You lose potential savings if rates fall but gain payment stability.

Making Extra Payments

Making extra principal helps shrink your overall loan balance. This lowers your interest expenses and reduces rate risk exposure as you have less principal subject to rate changes over time.

Conclusion:

In today’s high interest rate environment, it can be a very stressful time for exits. Planned exits from 2-3 years ago may not be what was underwritten and involves pivoting.

Hopefully you can use these strategies to figure out an exit strategy to retain your equity and not be underwater.

If you enjoyed this email, please respond to this. If you’d like to hop on a call, email me as well.

Thanks,

Mo