While financial headlines during the past year have been dominated by the credit crisis, auto-industry bailouts and bankruptcies, residential foreclosures, the stimulus package, and credit card defaults, something that hasn’t received as much attention in the general press is commercial real estate. Until now.
Many analysts are now speaking of commercial real estate as the other shoe that, if it falls, will bring the economy to new lows and reverse some of the market gains made in recent months. For those in the industry, this potential situation isn’t really news at all. We’ve been aware of this elephant in the room for some time.
One of the largest risks to self-storage owners is the availability of credit. Owners who are most vulnerable are those who acquired or built properties in the last three years during the market’s peak. Those who built or acquired using short-term, high-leverage debt, or who purchased facilities based on pro forma rents or leasing activity, face the greatest challenge.
The reality is the value of many properties in this category are likely not worth their current loan balance. Additionally, many properties acquired based on leaseup or rental projections are not servicing their debt, as the recession has curbed projections. Even properties that are performing but have debt coming due in the next 24 months are at risk of foreclosure.
So what can you do amid all this negative news and outlook? Most important, don’t hide from the problem. Address it aggressively and seek alternative solutions.
First, let’s look at properties with enough cash flow to service their debt but loans maturing soon. It’s crucial to contact your lender now to discuss an extension. In this market, it’s never too early to begin these discussions. This will allow you to gauge the lender’s health and determine if you need to prepare for a sale. If you’re successful, it will allow you to avoid being forced to sell or refinance.
If you need to refinance, you’ll be subject to a new appraisal and the accompanying risk of a lower value. A new appraisal will use a higher cap rate against income being pressured by a challenging economy. Couple this with the lower loan-to-value constraints being implemented by most lenders today, and there’s a strong possibility you’ll need to bring significant cash to the table at closing.
Regardless of whether you can negotiate an extension, if you believe there’s an equity gap, it would be prudent to set aside or reserve some of your current excess cash flow. By doing this, you essentially hyper-amortize your loan. If you’re forced to go to market and there’s an equity gap, you’ll have cash in reserve to help fill it.
Properties at Risk
If your property has adequate cash flow to service its debt and you’re faced with the possibility of a loan default and subsequent foreclosure, remember you’re not alone. This is important to a lender because it may demonstrate that current market conditions rather than the property owner are largely responsible for the loan’s nonperformance. It’s very expensive for a lender to foreclose on a property, so if the underlying weakness is due to market conditions, the lender may determine the most economical solution is to modify rather than foreclose.
Before contacting your lender, do your homework or get help from a mortgage professional to survey the financing market and identify potential alternatives to present to the lender. Once again, don’t hide, just seek solutions. This demonstrates a proactive approach and can prove a loan modification is the best scenario for everyone involved. Additionally, seek an investment-sales broker’s advice to help determine your property’s value and if selling it is a potential solution.
Loans originated by a portfolio lender (lenders who hold the loan on their balance sheet) are easier to negotiate than securitized loans, such as commercial mortgage-backed securities (CMBS), since you work directly with the entity holding the loan. A portfolio lender can make its own economic decisions and modify a loan at any time.
Conversely, CMBS or securitized loans administered by a third party, called the Master Servicer, cannot be modified until they are in technical default.
When a CMBS loan defaults, it’s transferred to another third party, the Special Servicer, who has the authority to modify the loan based on rules dictated by Real Estate Mortgage Investment Conduit tax laws and the “pooling and servicing” agreements governing CMBS loans. At the time of this writing, the U.S. Treasury was considering whether to issue guidance to make it easier to modify a CMBS loan.
If you get to the point of loan modification, some negotiating points you should consider discussing with your lender include:
- Extending the loan’s maturity date.
- Reducing the principal balance with a cash infusion, thus allowing the property’s cash flow to service the debt going forward.
- Reducing the interest rate to a level that allows the property’s existing cash flow to service the debt.
- Creating or increasing the interest reserve. If equity still exists or the property needs additional time to stabilize, the lender may agree to service the debt through additional reserves.
- Servicing the debt from other reserves, such as maintenance reserves or construction contingencies.
- Bringing in an additional guarantor with superior financial strength, thus boosting the lender’s confidence that the loan will be repaid at maturity.
- Offering the lender part of the upside in exchange for modifying the loan.
- Reducing the principal balance to an amount equal to or greater than what the lender would receive through foreclosure and fire sale.
- Conducting a short sale in which a buyer purchases the property at a price less than the principal balance. (If you can demonstrate it’s a market deal, then the lender avoids foreclosure costs and the borrower avoids future negative implications caused by foreclosure.)
- Cooperating with the lender to forgive your personal guarantee by handing the property over via Deed In Lieu, as opposed to fighting foreclosure through bankruptcy and minimizing the potential of the lender looking to your other assets for repayment.
This all may seem like a daunting task to tackle on your own, especially when your expertise is in operating a self-storage property. Rather than hiding from any potential financing problems, seek the expert support of attorneys, mortgage professionals and consultants who can guide you. Undoubtedly, we are in a tough market, requiring tough decisions. Your best chance for a positive outcome is to begin talking to your lender and other professionals sooner rather than later.
Devin Huber is a senior vice president with Beacon Realty Capital, a Chicago-based commercial real estate financing firm, where he supports self-storage owners nationwide with their lending needs. He can be reached at 312.207.8232; e-mail email@example.com.