Most commercial real estate investors are well aware of the financial turmoil that has occurred over the past several years. However, it may still come as a surprise to learn that despite the signs and sentiment of an apparent "recovery," there are currently more than $60 billion of securitized loans in some stage of actual default. Moreover, if one assumes that there is a similar amount of defaulted portfolio loans being held by banks, insurance companies, and other financial institutions, the sum quickly escalates to a nearly $120 billion of defaulted loans in the commercial real estate market. Although that number may be astounding, many industry experts estimate that the amount is even greater.
In fact, from the time that the recession began to present, the amount of CMBS loans in default went from less than 1% of total loans outstanding in 2007 to over 9% in August 2011, according to Trepp, LLC. Perhaps of greater concern, the number of Commercial Mortgage Backed Securities (CMBS) loans scheduled to mature in the "near" term (between now and 2017) is estimated at more than $400 billion and when adding the life company, bank and GSE products that are maturing, that number doubles.
The driving force behind the current problem relates to leverage, and perhaps the most serious issue facing commercial real estate investors today is the potential equity gap between the value of their property and the amount of their outstanding debt. According to Moody's/REAL Commercial Property Price Index, commercial real estate values have dropped by as much as 40% across the board from their peak in 2007 in the face of this recession.
Since it was not uncommon for commercial real estate assets to be purchased with an 80/20 debt to equity ratio, one does not need to be a mathematical genius to figure out that in light of post-recession valuations, assets may be worth much less than the outstanding debt amount. In fact, based on current estimates it is conceivable that up to 2/3 of all loans currently scheduled for maturity will not qualify for refinancing at an amount required to pay-off the existing debt.
A portfolio of storage assets generating $1.0 million in NOI five years ago, valued at an 7.5% cap rate, would have been valued at roughly $13.3M; this portfolio would have likely qualified for debt of around $10.6M in loan proceeds at 80% LTV. If we assume the loan was interest only with a five year call, a very realistic note in the glory days of commercial real estate finance, and that the maximum available leverage in today's market lies at 70% LTV, a proceeds shortfall at refinance of roughly $1.3M emerges.
|Cash Flow||Cap Rate||Value||LTV||Loan Amount||Short Fall|
|Current (no change)||$1,000,000||7.50%||$13,333,333||70%||$9,333,333||$1,333,33|
If we take this analysis a step further and assume that there has been some stress on the asset during the recession, resulting from either a deterioration of cash flow or an increase in cap rate, the magnitude of the shortfall can escalate rapidly. In this stressed example let's assume a pretty realistic increase in cap rates of only 50 basis points has occurred; this minor increase, combined with the new available 70% leverage, inflates the proceeds shortfall to almost $2.0M that will be needed to refinance the portfolio.
Although generic, these types of scenarios are very realistic because they illustrate the situation that many property owners, self-storage or otherwise, are currently faced with. This can present a significant problem, as many owners do not have the equity at their disposal that will be required to recapitalize the transaction. Candidly, an owner faced with this predicament is undoubtedly in a tough spot; however, depending on the specific situation, there are likely options available.
As a firm that specializes in arranging debt and equity financing for self-storage operators nationwide, The BSC Group has witnessed many different types of transactions face a myriad of difficulties over the past several years. Based on our experience, the magnitude of equity erosion often dictates the type of solution options available to the borrower. If the equity erosion is contained and there is cash flow available to service the debt, the simple subordinate debt options can present a pretty straightforward solution for filling a short term equity gap. In cases where equity erosion is more severe, however, a complete restructure of the debt may be a more viable solution for the borrower.
Subordinate debt is a general term that refers to any additional financing lower in priority to the first mortgage and is a mechanism that can provide additional dollars and higher leverage to help bridge an equity gap like the scenario above. In the current market, subordinate debt lenders will take a capital position between the first mortgage cut off and reach up to 85% or more LTV.
By reaching higher in the capital stack, subordinate lenders are inherently assuming more risk, and as such they get paid a higher rate of interest for doing so. Interest rates on subordinate debt can range anywhere from 8% to 18%, depending on the transaction. Subordinate debt lenders are often flexible and willing to structure the payments to match the cash flow projections of the specific transaction; for example, the payments might be structured as an IO payment with a balloon, or amortized over time via routine interest and principal payments to reduce the debt.
The two most common types of subordinate debt are Mezzanine Financing and Junior Mortgages, or B-Notes. Albeit similar in application, there exist critical differentiating factors that will dictate which is proper for the specific transaction at hand.
Mezzanine lenders provide subordinate debt that is secured against an ownership position in the borrowing entity, rather than the mortgaged property itself, as the collateral for the loan. It is essentially a pledge of the ownership interests in the property, rather than a pledge of property itself. As such, mezzanine debt is particularly useful in situations where the mortgage lender will not allow for secondary debt against the property collateral itself.
Alternatively, a junior mortgage is a secondary debt position that is secured by the mortgaged property as collateral for the loan. This mortgage is junior in priority to the first mortgage, or senior note (A Note), hence the nomenclature. The two mortgage notes will likely differ in their terms, however the payment priority is clear, with the A-Note having clear priority over the B-Note. Since both notes are secured by the same mortgaged property as collateral, however, the subordinate nature of the debt is established through an agreement between the A & B-Notes holders, referred to as the lender intercreditor agreement.
In cases where equity erosion is severe, and there is no longer adequate cash flow to service the existing debt, a complete restructure of the debt and equity may be a more viable option for the borrower. This effectively forces the sponsor to give up equity ownership and in some cases even the controlling interest in the ownership structure to entice new equity in to the transaction.
By definition, a joint venture is a business agreement whereby two or more parties agree to invest in a new entity and asset through the contribution of equity for a finite period of time. Together this new entity will exercise control over the enterprise and consequently share in the revenues, expenses and assets of the venture, the extent to which is determined during its negotiated formation. Joint venture equity is typically available to commercial property owners in transactions where there is a significant upside in the transaction, often stemming from a development or recapitalization scenario and resulting in enhanced cash flow and consequently value.
Joint ventures are heavily negotiated and can be structured in a multitude of ways depending on the specifics of the transaction. For example, in its most simplistic form, two parties could agree to contribute an equal amount of equity and subsequently split cash flow and profits equally going forward, until such time as the venture concludes.
Recapitalization transactions tend to be messy, and therefore the terms of the venture are more heavily dependent on considerations such as the balance of sponsor's equity remaining in the deal in proportion to the equity needed to recapitalize, as well as the perceived risk and reward associated with the transaction. There are key concepts that must be addressed when structuring a joint venture related to control, distribution of cash flow, and exit. It is imperative to understand who will control the venture, including the votes needed to make critical decisions, as well as matters of day-to-day operational control. In addition, it is important to understand how the cash flow from the venture will be distributed, with consideration given to profitable items such as salaries and management to the extent that one party or another is more involved in these aspects. Finally, both parties must premeditate and understand the likely exit options as they relate to each party's investment time horizon and motivating factors.
While refinancing in today's market can be a scary venture for those who are overleveraged, there are options available. With a little brainpower and ingenuity, storage owners can retain both ownership and control of their asset. Going forward, as new amortizing loans pay down the principal balance of the loan, it is less likely that these problems will occur again in the future.
This article has been reprinted with permission from Inside Self-Storage, the premier magazine of self-storage professionals. For information, visit www.insideselfstorage.com.
The BSC Group has been voted Best of Business - Finance for five years running by the readers of Inside Self-Storage.