With an impending wave of commercial real estate foreclosures, many contractors remain unaware that market valuation and appraisal methods—not underperforming assets or reduced rental income—are to blame.
One of the most serious threats to commercial property owners is loan maturity, which requires refinancing. Even if rentals and net income remained stable, an appraisal is still likely to determine a lower current property value.
Because the property itself is the major collateral for refinancing, an owner may not be able to refinance the remaining balance of a loan.
Cap Rates and Commercial Values
For example, assume a 100,000-square-foot office building with rents producing $1.5 million of net operating income was evaluated for a loan in 2006. One way to determine the building’s value is to apply a capitalization rate (cap rate) to the net operating income. Because cap rates reflect the investment’s return on the asset, they are useful in setting value. Cap rates also generally run two or three points above U.S. Treasury rates; however, that rule doesn’t necessarily hold with today’s increased risk in terms of real estate investment.
In 2006, a cap rate of 6 percent or lower was not unusual. Applying a 6 percent cap rate to the building’s $1.5 million net operating income produces a total building value of $25 million. Although lenders consider additional factors, this value will serve as the loan value to illustrate the threat of commercial foreclosure.
Also not uncommon in 2006 was an 85 percent loan-to-value ratio, in which the owner could reasonably get a loan of $21.25 million based on the collateral value of the building. With a 6 percent loan, three-year term and 20-year amortization of principal and interest, the remaining balance in 2009 would have been reduced to approximately $19.44 million. If the loan included an interest-only period, the principal balance would have been even higher.
To refinance the loan, the owner then would be looking for an amount of at least $19.44 million or higher. In the past, the owner also might use refinancing as an opportunity to free up some equity.
In 2009, valuation factors changed. Rather than cap rates of 6 percent, the owner is likely to find rates at 8 percent or higher. Using an 8 percent cap rate with the same $1.5 million net income, the value of the property is reduced to $18.75 million.
In addition, when the owner approaches lenders for refinancing, he likely will find stricter collateral requirements. Lenders now require no more than a 70 percent loan-to-value ratio as collateral. At that level, the maximum loan supported by the property is only $13.125 million—some $6 million less than the required loan payoff.
To refinance under these new financial realities, the owner will have to contribute significant equity or provide other unencumbered collateral.
As an alternative to cap rates, some lenders utilize a minimum debt-yield approach in which the net operating income is divided by the debt-yield figure, resulting in the maximum loan supported by the property. The debt-yield approach is attractive to lenders because it doesn’t depend on cap rates or appraisal methods, both of which can result in disagreements related to valuation.
A debt-yield analysis commonly requires a minimum of 11 percent to 12 percent. However, by applying a debt yield of 12 percent to the previous example, the property supports a maximum loan of only $12.5 million, further increasing the payoff shortfall.
Options in Today’s Changing Marketplace
In this example, neither the owner’s ability to pay nor the debt service coverage of the loan has deteriorated. The refinancing interest rate is likely to be lower than the current interest rate, and a lower principal amount would reduce payments if the amortization remains the same.
Therefore, the only factors responsible for the owner’s predicament are a decrease in the asset’s value coupled with a demanding lending environment. Of course, if any decrease in net income results, whether because rents decreased or vacancy increased, the problem will be aggravated even more.
This troubling scenario is driven in part by artificially low cap rates compared to historical cap rates. As a result, inflated values—coupled with an environment of looser credit underwriting—supported loans at levels that current values can no longer handle. As those loans mature, owners will be required to contribute additional equity.
Even if it is possible for owners to contribute this equity, the resulting deleveraging of debt will further reduce the return on investment.
It is essential for owners to begin working with existing and prospective lenders well before the loan’s maturity date. Owners with property portfolios can potentially use stronger properties to prop up the loans on those with less equity.
There are no easy solutions. Ultimately, lenders must determine whether they are willing to extend existing loans in the face of regulatory resistance, as collateral values may render those loans “nonconforming” under the current guidelines. If the lender is unwilling to extend current maturity dates and refinancing is unavailable without significant equity contributions, the owner may be forced into a default situation. While disruptive and unfortunate, this process will bring property values in line with reasonable cap rates and investment returns.