A Flush Refinance Market Offers Multiple Solutions
Borrowers may not like the current cost of capital, but often they don't have a choice.
The commercial real estate industry is going into the third consecutive year of a looming wall of maturities.
We first anticipated a wall to hit in 2024, driven by a combination of 10-year, fixed-rate loans that were originated in 2014; the first significant year of loan originations post-GFC; and two- and three-year bridge loans that were originated in 2021 and 2022 to finance value-add investments, primarily in multifamily.
In each of the last two years, we saw the same pattern: sponsors/borrowers testing the market for both a sale and refinance before ultimately returning to their current lender and receiving an extension and loan modification. During the past 12 months lenders have been less lenient with their borrowers resulting in an increase in activity in cash-in refinances. The combination of flat or negative rent growth in certain markets and product types, combined with rising treasury yields and rising cap rates, is leading sponsors to “hope for the best” and take a shorter-term loan in anticipation of improved fundamentals and valuations in the next three to five years.
Rate buydowns
With rates on five-year, maximum-leverage loans ranging from 6 to 7 percent, loan proceeds are typically DSCR-constrained and, therefore, borrowers and lenders are forced to make concessions to get to near-cash neutral refinances. One creative solution has come in the form of rate buydowns. Essentially CMBS and agency (max 2 percent) lenders will allow borrowers to reduce their spread by increasing their lender fee. The rule of thumb is that on a five-year loan 1 percent of upfront loan fee is worth about 23 to 25 basis points of spread reduction. Some borrowers are paying up to 3 to 4 percent upfront in order to push loan proceeds on CMBS loans that are underwriting to as low as a 1.15x DSCR on an interest-only basis.
Preferred equity and mezzanine
Another solution has been a bridge-to-bridge loan with higher-priced, 8 percent (SOFR + 4.25 percent) loans sizing their proceeds to 1.0x DSCR on an IO basis. These loans are typically flexible on prepayment and are favored amongst borrowers that anticipate an exit within the next 12 months.
Lastly, preferred equity and mezzanine loans have provided borrowers with additional leverage when rate buydowns and bridge-to-bridge refinances don’t provide the necessary leverage and the borrower is unable to fund additional capital. As yields on preferred equity have compressed in recent years, many providers are targeting 10 to 12 percent annual yields on their capital. This provides the ability to bifurcate that return into a current pay and an accrual in order to be able to pay a current yield on this capital.
In all, we have a very liquid debt market. While borrowers don’t like the cost of the debt today, most don’t have a choice and are benefiting from creative options along with aggressive underwriting. These alternatives help achieve loan amounts that either fully refinance or come close to refinancing their existing debt.
Shlomi Ronen is managing partner at Dekel Capital Inc.
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