The Dangers of High LTV and Short-Term Debt in Commercial Real Estate
“When the tide goes out, we’ll find out who’s swimming without a bathing suit”
I’m writing this in April 2020, and the tide seems to be going out.
Have you noticed? Did you hear about what’s going on? So apparently someone in Wuhan, China ate a bat or something...
OK enough joking around. Seriously, commercial real estate is facing a day of reckoning. A day we knew was coming. We have been warning everyone who would listen on BiggerPockets and on podcasts, etc., since 2017.
You see, commercial real estate is unlike residential, the realm many of us are most familiar with. A typical residential mortgage provides a locked-in interest rate and payment for 30 years. But most (not all) commercial debt has a five, seven, ten, or twelve-year term with a balloon payment at the end. (Some riskier bridge debt has a term of a few years with a balloon.) Which means that it will need to be refinanced (or sold) at the end of the term.
The credit cycle, like other economic cycles, loosens and tightens with events and emotions in the market and investor/banker psychology. At the arguable “beginning” of a cycle, investors and lenders have a “neutral” attitude toward risk and financing. As markets improve, equity comes rushing toward a wider variety of deals, and diligence standards weaken.
The issuance of debt follows the same psychology. As investing becomes popular on the street, more capital rushes to riskier deals and investors start to wonder how anything can go wrong. These are “the good times.”
The problem with these “good times” is that this is the time of shrinking returns (due to rising asset prices). This is exactly when investors and lenders should increase their diligence. But in reality, it’s often when they do the least. This is the time when some smart operators are exiting. And dumb money (as they call it) is rushing into the riskiest investments. It is a race to the bottom among investors, lenders, and operators.
This is also the time when riskier debt is put on projects. Leverage can make a good deal great, and of course all the deals are “amazing” at this point in the cycle. This risky debt can take the form of floating interest rates, high LTVs (loan to value ratios), longer interest-only periods, and shorter terms.
At the same time, operators – counting on continual revenue bumps and appreciation – are overpaying for assets and over-raising equity. Appreciation, they reason, will allow the first sin to go unpunished. And the extra equity will fund investor returns until the project really makes a profit. By the time the interest-only period ends, investors will be rolling in dough, right?
All of these actions are stacking logs in the fireplace for the next bonfire. But none of these things is enough to start the fire.
An igniter is needed.
That igniter shows up in the form of an economic shock or an exogenous event. This can be a month or quarter of economic contraction (like 1980). It could be the failure of a market segment (the bankruptcy of leverage buyout companies, the collapse high-yield junk bonds, and the imprisonment of Michael Milken in 1990). It can be an attack or a war that we get dragged into (like 9/11). Or, as we’ve recently learned, it can be a virus brought from a far corner of the world.
“What the wise do in the beginning, fools do in the end. ”
This is when the house of cards starts toppling. The bonfire is ignited. Investors who rushed in with little care or concern are now looking for the exits. Suddenly due diligence is king. Safety of principal abruptly takes center stage. Those who were eyeing massive profits are now hoping to exit with minimal losses. Many investors who recently threw caution to the wind resolve to never invest again.
Lending follow the same pattern. (This is important to this discussion.) Standards tighten. LTV levels drop. Reserve requirements are increased. As an example, agency lenders (Freddie and Fannie) are currently requiring borrowers to set aside 12 to 18 months of principal and interest reserves. This is a heavy burden for borrowers, and it puts a significant drag on investment returns.
Almost everyone is selling. Almost no one is buying. No one wants to catch a falling knife.
This cycle continues in a downward spiral until no more air can be let out of the tires. Opportunistic investors, sensing a bottom has been reached, trickle in and start scooping up discounted deals. Word starts leaking out about early profits being enjoyed by smart investors. Other investors tiptoe in the end of the cycle is reached. A new cycle begins... and investors and lenders alike appear to have amnesia as they take the next plunge.
I love the quote from John Kenneth Galbraith (from A Short History of Financial Euphoria and quoted in Mastering the Market Cycle by Howard Marks) on this topic...
So What happens to commercial real estate investments in downward cycles?
We all know what can happen to equity investments in a time like we’re experiencing. We know that some investors recently lost 10 to 30 percent of their portfolio. Those unfortunate enough to have leveraged holdings lost more. I know of someone who lost over 60%.
Investors in publicly traded REITs fared similar to the rest of the stock market. Here is a recent chart showing average performance among REITs since this crisis began.
Now if you think like Buffett, an investor who “lost” tens of billions at Berkshire Hathaway in this downturn, you didn’t lose a thing. As a long-term holder of equity, he views these “losses” as opportunities to buy more stock... his and others... at a discount.
Long term holders of real estate investments can think similar to Buffett. As long as they can refinance their debt. Investors in private commercial real estate don’t have to fear the short-term, fear-driven values reported in the numbers above.
What happens to debt-encumbered private real estate holdings? In good times, leverage allows for accelerated profits and appreciation. At 66.7% LTV, cash flow is increased (net of debt service) substantially. Appreciation is effectively tripled (compared to asset appreciation) for equity investors, a benefit that is enjoyed fully at the sale of the asset.
What are the effects of leverage in a declining market?
Leverage can adversely impact commercial real estate investors, and it can potentially wipe them out. There is downward pressure on revenue and income. There is an expansion of the cap rate (lower values). Tightened loan standards and reserve requirements make it harder to qualify to refinance. Remember the value formula for commercial real estate:
Let’s look at a quick example...
Suppose you acquired an apartment complex at a 5.5% cap rate with annual income of $100,000. The purchase price was $1.818 million. Let’s say you need the rents to go up by 8% over two years to cover debt payments and equity returns when the interest-only period ends.
Green Street Advisors predicts that apartment NOI (net operating income) will drop 8% by 2022 from 2019 levels. That is 15% below previous projections (see lower-right graph). An 8% drop in NOI translates to an 8% drop in the value of the property per our formula.
Now if cap rates (the denominator) expand by 1.5 points, to 7.0%, that compounds the value problem for owner/investors. This alone will drop the value of the asset by over 21% (about $389,000: from $1.818 million to $1,429 million).
The combined impact of lower NOI and the expanded cap rate is a 35% drop in value (from $1.818 million to $1.314 million).
If you’re a cash owner, like Buffett is with his equities, you patiently ride out this storm. If you have low LTV debt, you refinance when your term is up. But what if you were at 75% LTV (or even higher) when this match was lit? You’ll find yourself underwater. How?
When you go to refinance your 75% LTV $1.363 million debt, your total asset value will only be $1.314 million. At 75%, you will only be able to refinance for $985k. You’ll have to come up with about $378k in new equity just to stay afloat. And the value of your old plus new equity, at least at that moment, will be zero or less.
But it’s worse than that...
Bank standards will have tightened, and you may not get a 75% loan anymore.
Decreasing rents may result in trouble making debt payments, and with a falling credit score, you may no longer be viewed as a good risk.
Interest rates could be higher.
Reserve requirements could mean that you need to come up with 12 to 18 months in extra reserves.
You will have trouble getting new equity if your current equity holders’ value is underwater.
In short, you may find yourself up crap creek without a paddle.
I hope that none of you are in this situation, with your investments, or with others.
Debt Service Coverage Ratio
The loan-to-value ratio is a great way to gauge the initial margin of safety on your debt. But a more comprehensive way to measure initial margin of safety, and the safety margin at any point in the life of the investment, is through the debt service coverage ratio (aka the DSCR, the debt coverage ratio, or the DCR).
The DSCR is defined as “a measurement of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking fund, and lease payments.” (Investopedia)
Typically, lenders want to see a DSCR of about 1.25 or more. This provides a 25% margin of safety. If your net operating income is $100,000, from our example, a lender would want to assure that principal and interest payments don’t exceed $80,000 annually ($100k ÷ 1.25).
If the cycle is in decline, many lenders will have closed up shop for new debt. But those who are lending may increase the DSCR to (say) 1.35. This causes trouble for our over-leveraged operator who also must contend with shrinking NOI at $92,000. Now the maximum debt service will be about $68k annually ($92k ÷ 1.35). Another sign that this operator may need SCUBA gear.
Conservative investors and operators don’t want to live near the margin. A conservative investor may want to see a DSCR of 1.5 or more, providing a 50% margin of safety.
Conclusion
If you made it this far, thanks for reading this long essay on market cycles and debt. If you have further questions, please email us at invest@wellingscapital.com or use this scheduling link to set up a call.
Real estate investments and securities offerings are speculative and involve substantial risks. Please do your own research, draw your own conclusions, and seek professional advice. The information contained in this article is for informational purposes only and is not intended to provide investment advice. Investors should consult their own tax, legal and accounting advisors before engaging in any transaction.