CREJ - Office Properties Quarterly

April 2015 — Office Properties Quarterly —

Page 3

Finance Market

ollowing are some insights

regarding the current financ-

ing environment for perma-

nent loans for office build-

ings.

Overall, how receptive are perma-

nent lenders for office building loans?

Over time, life insurance compa-

nies tend to vary widely relative

to their interest for office build-

ing loans, depending on their per-

ception of the economy and the

respective loan exposure to that

property sector or local market.

Since the Denver office market is

quite strong, office building loans

are candidates for all life companies

and commercial mortgage-backed

security lenders, as well as banks

and credit unions. CMBS loans may

be the best option for longer-term

nonrecourse financing for office

product, especially for higher-lever-

aged transactions.

How does a central business dis-

trict location compare with a subur-

ban location for lender preferences?

For life companies, there is some

bias toward a CBD location or infill

areas like Cherry Creek, where there

are higher barriers for development.

Nonetheless, there are many strong

suburban office parks or concentra-

tions of office development in the

Denver area that have demonstrat-

ed consistent market occupancy

levels over the years. Lenders are

more cautious about generic office

product, where buildings can com-

pete only with rent levels.

How would you define a “gener-

ic” office building?

A building built in the 1970s or

1980s that has lower ceiling heights,

limited common-area amenities,

older mechanical systems, narrow

hallways, challenging floor plans or

bay depths, and low parking ratios

(3.5 spaces per 1,000 square feet or

less). Most of these buildings pos-

sess permanent functional obsoles-

cence that is difficult to cure.

How are generic buildings best

financed?

Generally a life insurance com-

pany lender will require a very con-

servative loan structure or personal

recourse. Banks or credit unions

are logical candidates. CMBS lend-

ers are the best option for a nonre-

course loan for generic buildings,

especially where higher leverage is

needed.

Why is a CMBS loan worth con-

sidering?

Many borrowers have indicated

that they would never use a CMBS

lender again after dealing with

loan administration and defea-

sance nightmares over the past few

years. However, the main reason

for an owner to consider a CMBS

finance execution is to achieve a

nonrecourse loan with highest pos-

sible leverage level, say 75 percent.

In addition, the loan amortization

likely will be 30 years or could

include a few years of interest-only

payments. The debt constant will

be lower compared with a life com-

pany option, even though the inter-

est rate may be higher. For exam-

ple, a full-leverage CMBS 10-year

fixed-rate loan at 4.5 percent with

a 30-year amortization has a debt

constant of 0.061. This compares

with a life company constant of

0.065 using a rate of 4.25 percent

with a 25-year amortization for the

same property.

The downsides of a CMBS loan

include funded reserves for tenant

finish, leasing commissions and

capital expendi-

tures; a two- to

three-year lockout

period for any pre-

payment option;

and a defeasance

prepayment struc-

ture. There are

also covenants

for minimum

debt coverage of

approximately

1.10 that trigger

a requirement

for the tenants to

remit rents to a

lender-controlled

lock box. Lender legal fees for clos-

ing the loan are much higher than

for other lenders. There are myriad

loan administration issues for lease

approvals, loan assumptions, and

other property or borrower issues

that are subject to master or spe-

cial servicer review, which can have

lengthy time delays.

At some point in the future,

defeasance may be a valuable

option when interest rates are

normalized again. In the example

above, if at the time of prepayment

the treasury rates are more than 4.5

percent for the matching maturity

date of the loan, the loan would be

paid off at a discount.

Can you discuss how life compa-

nies approach office building under-

writing?

First, they tend to be more conser-

vative regarding capitalization rates

for defining value regardless of an

actual purchase price or Member

of the Appraisal Institute appraisal

value. Second, their loan-to-value

ratios tend to be 65 percent or less,

based on their internal value. Third,

they will be more selective than

CMBS regarding the sponsor and

the cash investment in the transac-

tion. Fourth, a 30-year amortiza-

tion or interest-only payments are

exceptions. A typical amortization

schedule will be 25 years.

One distinct advantage that life

companies can offer is with regard

to options for prepayment flex-

ibility, although there always will

be some element of call protection

for a portion of the term. Life com-

panies can offer fixed-rate terms

anywhere from three to 30 years,

although at least one lender started

offering a 40-year term.

There is a significant lender com-

petition for low-leverage loans (sub-

60 percent), for core or core-plus

asset quality, for properties in “A”

locations and for a strong financial

ownership group. With the 10-year

U.S. Treasury yields currently hover-

ing around 2.25 percent, an inter-

est rate of 3.5 percent is likely for

a 10-year term. (There has been a

spike in the 10-year Treasury rate

from 1.65 percent to 2.25 percent as

of March 6, and the all-end rate in

this example would have been clos-

er to 3 percent on Feb. 1). Interest-

only payments for part of the term

can be expected for leverage levels

closer to 50 percent.

What are some other office build-

ing finance challenges?

The greatest challenges are relat-

ed to single-tenant buildings. In

addition to the lease maturity event

risk, there is also a tenant’s credit

background, as well as its competi-

tive business sector to evaluate. As

a general rule of thumb, most lend-

ers will require a funded reserve

account via a cash flow sweep in

order to accumulate a sufficient

amount of funds for re-tenanting

costs and possibly an interest

reserve of one years’ debt service.

This reserve easily could exceed $30

per sf in most cases. Some lenders

try to mitigate the default risk with

a “springing” personal recourse cov-

enant.

Single-tenant buildings with a

noncancellable long-term lease (15

years or more) with an investment-

grade credit tenant can be easily

financed using a fully amortized

loan matching the lease term or

with a small residual loan balance

“hang-out” (amortization extending

three to five years beyond the lease

term), provided the estimated build-

ing value or land value will provide

a refinance cushion at the time of

the loan maturity.

Another problem to address is

office properties that have a sig-

nificant exposure to large tenant

leases that rollover during the loan

term, or those leases expiring a few

years beyond the loan maturity. The

normal solution is to have funds

reserved for those events.

A multitenant building with a

staggered lease rollover schedule is

what most lenders prefer. Since the

CBD and primary suburban build-

ings have a mixture of lease terms

anywhere from three to 10 years,

these examples fall perfectly into

the strike zone. Generic buildings

typically will have one- to five-year

lease terms and noncredit tenants.

These situations will require more

conservative underwing and per-

haps personal recourse.

What advice do you have for a

typical office building owner regard-

ing financing options?

Every borrower has a unique strat-

egy that he wants to explore. All of

the property characteristics, includ-

ing legal and title issues, will dic-

tate a distinctive approach to solv-

ing the financing priorities. Every

loan request needs to be exposed to

a wide array of lenders, as many as

25 in most cases. There are so many

variables and risk perceptions that

only can be qualified after a lender

has dug into the background of a

transaction.

To sort out the lender alterna-

tives, a borrower should work with

a financing intermediary that has

the ability to network with a diverse

group of portfolio lenders. In addi-

tion, an experienced intermediary

will be able to recommend various

aspects of a loan structure that bor-

rowers may not know are available.

Even CMBS lenders can differentiate

from one another, although they

ultimately must adhere to industry

standards regarding loan underwrit-

ing rules with some small pricing

variance. In summary, every loan

transaction is analogous to a puzzle

and office buildings have a lot of

pieces that need to be connected.

Financing for permanent office building loans

Stephen P. Bye

Executive president

and senior

managing director,

NorthMarq Capital,

Denver