It’s difficult to imagine a more tumultuous time for commercial-property owners. They have lost tenants and have been forced to offer concessions to bolster occupancy rates and shore up what cash flow they can. In the early months of the COVID-19 pandemic, no one thought this trend would last, but some landlords have already entered their second leasing cycle with discounted rents.
Too many commercial real estate owners are risking default on long-term loans. As owners exhaust cash reserves and credit lines, more of them will likely seek to pull cash out of their properties. Although these borrowers sailed through the financing process in the past and qualified for the best interest rates, many now can’t get approved for long-term loans given their cash crunch. For these borrowers and their mortgage brokers, it is time to think outside the box.
Although it defies conventional wisdom, refinancing longer-term debt into a higher-interest, short-term bridge loan is one way out for some cash-strapped commercial real estate owners to keep their struggling properties and stabilize them. This otherwise extraordinary action makes sense for several reasons.
First, your borrower may need cash to upgrade the building for new tenants but may be unable to meet the debt-service-coverage ratio (DSCR) on a long-term cash-out refinance. A short-term bridge loan, however, offers a path to be creative.
With a bridge loan, for example, the borrower may have the opportunity to establish a loan-funded interest reserve, whereby the lender advances funds to pay interest on the loan and the payment is added to the loan balance. It can be used by the owner to weather lean months of income, or to free up cash for property improvements and rehabilitation. Although this is not a direct substitute for a cash-out refinance, an interest reserve can be a way for strapped owners to avoid selling at a discount and losing the future income stream.
Bridge loans also can be used by opportunistic buyers. Investors looking to pick up a struggling commercial property are likely to run into the same problems with long-term financing. If the property is underperforming, low-rate lenders will likely take a pass. But locking in a bridge loan to acquire a property can give the buyer an edge over competing bids. Once the income is restored and the property is stabilized, the borrower can look at refinancing the bridge loan into a lower-interest, long-term option.
Bridge loan interest is typically higher than that of permanent loans, but not as high as many business credit lines. A bridge loan, combined with an interest reserve, allows borrowers to break the cycle of using unsecured business lines to make up monthly shortfalls on mortgage payments. When considering whether a bridge loan is the best option, however, you’ll need to estimate the property’s potential return on investment from the projected income as a way to justify the cost of the loan.
Bridge loans often have the flexibility to be extended beyond the normal term of 12 to 24 months, which is especially helpful during times of economic uncertainty where it can take longer for some assets to stabilize. Conversely, if the economy recovers more quickly than predicted, bridge loans are sometimes available with little or no prepayment penalty.
Lenders live and die by the numbers. But the question of, “How will you pay me back?” can’t always be answered with spreadsheets. There’s often a story that transcends the numbers. By telling this story, a borrower can breathe some life into a sleeper deal that would otherwise be declined.
As a general practice, lenders are not looking for potential — not unless someone points it out. There are many stories out there and some have happy endings.
Take, for example, the case of one borrower who went beyond the numbers to obtain a loan by telling the real story of the property’s potential. This borrower owns two adjacent properties near the beach in a seaside resort town. One property is a parking lot that generates stable income in good times. The other property is leased to a company that was constructing a family attraction. The parking lot stands to benefit from the family attraction which, in turn, is expected to draw traffic from the beach about a block away.
Still, the borrower could not qualify for long-term financing. Like so many commercial real estate assets, 2020 income was depressed. The DSCR wasn’t acceptable for a conventional long-term loan and neither property was stabilized. The owner’s current loan was set to mature and he was at risk of default.
After previously being declined for a long-term loan, the borrower tried again with another lender. He was open to a bridge loan, but at first blush, he didn’t qualify for that either because of the depressed income. The lender applied a conservative capitalization rate when determining the loan-to-value (LTV) ratio. At this low cap rate, the loan amount still didn’t make sense.
But the borrower had facts to back up his assertions of higher value. He advocated for a recalculation based on pre-pandemic income and the predicted success of the new business with its potential to generate significantly increased traffic for both properties. The parking lot historically generated high income and likely would do even better once the borrower overcame the current roadblock.
He also felt strongly that the cap rate and comparables the lender was applying to the properties didn’t track what they would appraise for. He had documentation to support this. This was, arguably, a gray area. The borrower had a strong working knowledge of his industry and a solid plan. This loan had a story. The bridge lender listened and liked the story.
Initially, the borrower asked for a little more than $14 million. The loan file moved from the decline stack to an offer of roughly $19 million, with the bulk of the funds to be provided at closing. The borrower also had the right to earn-out the remaining funds as the projected income stabilized.
Advocacy paid off. By telling a story, the borrower made a convincing case for an exception. The borrower’s business plan now has a chance to mature. Otherwise, he might have been forced to sell the property at a discounted price before the income potential could be realized.
It is possible to use bridge financing to fund certain assets, such as retail, that are out of favor. Retail centers are particularly difficult to finance right now. Many lenders are declining loan requests due to higher numbers of rent concessions, late rent payments and tenant defaults. But in another example of a story loan, one borrower was able to make the case for an exception.
In this case, the borrower owned a 16,000-square-foot retail center in the South. The property included more than 20 tenants, including a dentist’s office, a tax service, several hair salons, a music store, a catering company and even a church.
By looking at the tenants one by one, it was apparent to the lender that the majority were paying rent on time. This was clear from the rent-roll and bank-deposit records that provided corroboration. Many tenants had been in place for years, which added strength and predictability to future income projections and the all-important DSCR.
When funding retail assets in particular, it is important to consider the tenant mix. Lenders are not only looking at tenant payment habits but also at the tenant types relative to businesses most severely affected by the pandemic. These include restaurants, bars and hair salons. This retail center had relatively few higher-risk businesses. By pointing this out, the borrower was able to demonstrate decreased risk.
The subject property appraised for much less than anticipated. With a lower property value, a cash-out refinance did not appear realistic. The lender’s initial term sheet provided for an LTV of only 60%. But after hearing about the property’s compensating factors, the lender reconsidered and raised the LTV to 70%.
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As we all recover from the turmoil of the past year, the lesson of the story loan is more vital than ever for commercial mortgage brokers to close loans and aid cash-strapped clients. Right now, lenders are skeptical — and they need to be. But that doesn’t mean borrowers can’t make their case. Smart lenders will listen. ●