CREJ - Office Properties Quarterly - April 2015
Following are some insights regarding the current financing environment for permanent loans for office buildings. -Overall, how receptive are permanent lenders for office building loans? Over time, life insurance companies tend to vary widely relative to their interest for office building loans, depending on their perception of the economy and the respective loan exposure to that property sector or local market. Since the Denver office market is quite strong, office building loans are candidates for all life companies and commercial mortgage-backed security lenders, as well as banks and credit unions. CMBS loans may be the best option for longer-term nonrecourse financing for office product, especially for higher-leveraged transactions. -How does a central business district location compare with a suburban location for lender preferences? For life companies, there is some bias toward a CBD location or infill areas like Cherry Creek, where there are higher barriers for development. Nonetheless, there are many strong suburban office parks or concentrations of office development in the Denver area that have demonstrated consistent market occupancy levels over the years. Lenders are more cautious about generic office product, where buildings can compete only with rent levels. -How would you define a “generic” office building? A building built in the 1970s or 1980s that has lower ceiling heights, limited common-area amenities, older mechanical systems, narrow hallways, challenging floor plans or bay depths, and low parking ratios (3.5 spaces per 1,000 square feet or less). Most of these buildings possess permanent functional obsolescence that is difficult to cure. -How are generic buildings best financed? Generally a life insurance company lender will require a very conservative loan structure or personal recourse. Banks or credit unions are logical candidates. CMBS lenders are the best option for a nonrecourse loan for generic buildings, especially where higher leverage is needed. -Why is a CMBS loan worth considering? Many borrowers have indicated that they would never use a CMBS lender again after dealing with loan administration and defeasance nightmares over the past few years. However, the main reason for an owner to consider a CMBS finance execution is to achieve a nonrecourse loan with highest possible leverage level, say 75 percent. In addition, the loan amortization likely will be 30 years or could include a few years of interest-only payments. The debt constant will be lower compared with a life company option, even though the interest rate may be higher. For example, a full-leverage CMBS 10-year fixed-rate loan at 4.5 percent with a 30-year amortization has a debt constant of 0.061. This compares with a life company constant of 0.065 using a rate of 4.25 percent with a 25-year amortization for the same property. The downsides of a CMBS loan include funded reserves for tenant finish, leasing commissions and capital expenditures; a two- to three-year lockout period for any prepayment option; and a defeasance prepayment structure. There are also covenants for minimum debt coverage of approximately 1.10 that trigger a requirement for the tenants to remit rents to a lender-controlled lock box. Lender legal fees for closing the loan are much higher than for other lenders. There are myriad loan administration issues for lease approvals, loan assumptions, and other property or borrower issues that are subject to master or special servicer review, which can have lengthy time delays. At some point in the future, defeasance may be a valuable option when interest rates are normalized again. In the example above, if at the time of prepayment the treasury rates are more than 4.5 percent for the matching maturity date of the loan, the loan would be paid off at a discount. -Can you discuss how life companies approach office building underwriting? First, they tend to be more conservative regarding capitalization rates for defining value regardless of an actual purchase price or Member of the Appraisal Institute appraisal value. Second, their loan-to-value ratios tend to be 65 percent or less, based on their internal value. Third, they will be more selective than CMBS regarding the sponsor and the cash investment in the transaction. Fourth, a 30-year amortization or interest-only payments are exceptions. A typical amortization schedule will be 25 years. One distinct advantage that life companies can offer is with regard to options for prepayment flexibility, although there always will be some element of call protection for a portion of the term. Life companies can offer fixed-rate terms anywhere from three to 30 years, although at least one lender started offering a 40-year term. There is a significant lender competition for low-leverage loans (sub- 60 percent), for core or core-plus asset quality, for properties in “A” locations and for a strong financial ownership group. With the 10-year U.S. Treasury yields currently hovering around 2.25 percent, an interest rate of 3.5 percent is likely for a 10-year term. (There has been a spike in the 10-year Treasury rate from 1.65 percent to 2.25 percent as of March 6, and the all-end rate in this example would have been closer to 3 percent on Feb. 1). Interestonly payments for part of the term can be expected for leverage levels closer to 50 percent. -What are some other office building finance challenges? The greatest challenges are related to single-tenant buildings. In addition to the lease maturity event risk, there is also a tenant’s credit background, as well as its competitive business sector to evaluate. As a general rule of thumb, most lenders will require a funded reserve account via a cash flow sweep in order to accumulate a sufficient amount of funds for re-tenanting costs and possibly an interest reserve of one years’ debt service. This reserve easily could exceed $30 per sf in most cases. Some lenders try to mitigate the default risk with a “springing” personal recourse covenant. Single-tenant buildings with a noncancellable long-term lease (15 years or more) with an investment grade credit tenant can be easily financed using a fully amortized loan matching the lease term or with a small residual loan balance “hang-out” (amortization extending three to five years beyond the lease term), provided the estimated building value or land value will provide a refinance cushion at the time of the loan maturity. Another problem to address is office properties that have a significant exposure to large tenant leases that rollover during the loan term, or those leases expiring a few years beyond the loan maturity. The normal solution is to have funds reserved for those events. A multitenant building with a staggered lease rollover schedule is what most lenders prefer. Since the CBD and primary suburban buildings have a mixture of lease terms anywhere from three to 10 years, these examples fall perfectly into the strike zone. Generic buildings typically will have one- to five-year lease terms and noncredit tenants. These situations will require more conservative underwing and perhaps personal recourse. -What advice do you have for a typical office building owner regarding financing options? Every borrower has a unique strategy that he wants to explore. All of the property characteristics, including legal and title issues, will dictate a distinctive approach to solving the financing priorities. Every loan request needs to be exposed to a wide array of lenders, as many as 25 in most cases. There are so many variables and risk perceptions that only can be qualified after a lender has dug into the background of a transaction. To sort out the lender alternatives, a borrower should work with a financing intermediary that has the ability to network with a diverse group of portfolio lenders. In addition, an experienced intermediary will be able to recommend various aspects of a loan structure that borrowers may not know are available. Even CMBS lenders can differentiate from one another, although they ultimately must adhere to industry standards regarding loan underwriting rules with some small pricing variance. In summary, every loan transaction is analogous to a puzzle and office buildings have a lot of pieces that need to be connected.