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February 23, 2018  

Rate Rise Seen Squeezing CMBS Loan Sizes

Conduit lenders say that rising long-term interest rates are likely to lead to a “pinch in proceeds” for borrowers before long.

The 10-year Treasury yield has spiked by 55 bp since Dec. 1, to 2.92% yesterday. For borrowers, some of that increase has been offset by a decline in loan spreads driven by the bond-market rally. But there is more sentiment now than a month ago that long-term rates will continue to rise, fueled by an expanding economy and inflation fears.

If the cost to borrowers does keep increasing, lenders will be pressured to reduce loan sizes in order to maintain debt-service-coverage ratios. In fourth-quarter conduit deals, property cashflows were 2.2 times the amount needed to service debt, reflecting a tightening of credit standards following the implementation of risk-retention regulations. While conduit shops may have some leeway to reduce that ratio, market forces will limit that flexibility.

So far, the impact on borrowers has been muted. For loans already in the origination process, lenders evidently aren’t broadly seeking to renegotiate lower loan sizes. “There’s a lag time in conduit loans,” said one longtime lender. “It often takes three or four months to put a loan together, so you’re not seeing the interest-rate rise reflected yet. It would be premature to say that rising rates have pushed proceeds down. But they will. We’ll probably start to see it in the second quarter.”

That would only add to headwinds faced by the conduit sector. A cyclical downturn in loan maturities and a decline in property acquisitions are already reducing loan demand. While first-quarter commercial MBS issuance has been relatively strong, some conduit pros fear that the volume will tail off later in the year amid soft loan demand.

“Almost every shelf is moving slower than they’d expected, because some lenders here and there are struggling to close their loans,” said one veteran conduit lender. “If you start to see loans getting re-sized, that would only get worse.”

A decrease in the size of senior mortgages could force property owners to use more mezzanine debt. For example, consider an owner that wants to borrow $10 million on a property that generates $900,000 of net operating income. It might currently qualify for a 4.5% senior mortgage, resulting in $450,000 of annual debt service, or a 2:1 debt-service-coverage ratio. But if the rate rises to 5%, the loan’s size would have to be reduced to $9 million to maintain that ratio, leaving the borrower to look elsewhere for the additional $1 million.

One lender at a mezzanine-loan shop said he has fielded a few calls from conduit shops on behalf of borrowers that need supplemental debt because of rising coupons. But such activity has been only sporadic to date, according to conduit pros.

In the past, a shift toward higher interest rates sometimes led to a short-term boost in loan demand, as borrowers moved to refinance early to lock in lower rates. It’s too soon to tell whether that might happen now, according to the CMBS chief at one leading shop, because some property owners think the rate-spike might be short-lived.

“There’s a real mix of opinion on that,” he said. “Some borrowers think they might benefit by waiting, because rates might back up. I think there are just as many people willing to bet that it’ll be better down the road as people who think it’ll be worse.”