Investment Analysis

Adjusting the Rules of Refinancing

The economic fallout of the COVID-19 pandemic will have long-lasting effects on refinancing in commercial real estate.

While state and municipalities across the U.S. begin to reopen after COVID-19 lockdowns, commercial real estate owners with near-term loan maturities have no choice but to prepare to refinance their loans. The possibility of a technical default, exorbitant default fees, and the commencement of foreclosure proceedings should never be taken lightly. While some lenders may offer these borrowers extensions, owners need to be 100 percent prepared to refinance properties unless they have already received a loan extension or a loan modification document.

The lending landscape has drastically changed post-COVID-19. The good news is that loans collateralized by multifamily properties and manufactured home communities are currently available through government-subsidized programs like Fannie Mae, Freddie Mac, and FHA/HUD, which are similar to pre-COVID-19 loans. Even though these loans remain the best option for property owners, lenders will require new forms of documentation and offer less leverage than before the pandemic.

Owners should hire experienced mortgage professionals (ideally those with post-COVID-19 loan closing experience) to negotiate on their behalf as it relates to newly created six- or 12-month debt service, real estate tax and insurance reserves (regardless of property performance), new cash-out limitations, interest-only period reductions, and lower loan-to-value requirements. Remember, loan terms are the single most effective way for a commercial real estate owner to maximize their after-debt service cash flow and return on equity.

Owners need to be 100 percent prepared to refinance properties unless they have already received a loan extension or a loan modification document.

For non-residential commercial real estate properties, the lending options are much more limited, and the air has gotten extremely thin. As of early June, a reputable commercial mortgage-backed securities “money center bank” has re-emerged and is providing much-needed liquidity in the marketplace, though the CMBS market is not widely open for business.

Insurance companies, for the most part, have retreated on their lending activity, except for the most conservative loan terms. They are in a wait-and-see approach, which is common during periods of economic uncertainty. Some local and regional banks are still open for business, but nearly all of them require full or partial recourse, which does not work for certain borrowers or institutional sponsors. Lastly, debt funds and specialty finance companies have been the lenders that have generally been the most negatively impacted by COVID-19. The evaporation of CLO securitizations - or collateralized debt obligations, which up until COVID-19, provided many of these lenders with significant liquidity - has crippled their ability to actively lend. In addition, debt funds and specialty finance companies have been hammered with heavy margin calls by their line or repo lenders. Consequently, some debt funds and specialty finance companies are currently hoarding cash to ensure they can make future margin calls and survive.

Lenders' appetites have also changed on an asset-by-asset basis after COVID-19. One asset type that is currently in relatively high demand by lenders is self-storage. Many lenders have recognized that this niche market sector has remained relatively unscathed by COVID-19. The basic demand generators of self-storage (including death and divorce) persist, regardless of economic turmoil, and COVID-19 has produced new temporary demand including the space needed to accommodate newly established home offices or young people who have moved back home with their parents.

Financing is available for industrial properties, but lenders are focused on determining which industrial tenants have retail exposure. Lenders are also reviewing loan proposals collateralized by office properties; however, some lenders recognize that COVID-19 may have accelerated the work-from-home model, which could decrease the long-term demand for office properties. Lenders are also particularly focused on office tenants with near-term lease expirations because they may choose not to renew, to reduce their space, or to ask the landlord for significant tenant improvement dollars to incentivize lease renewal.

Financing for retail facilities is mostly limited to essential outlets, such as pharmacies and well-performing grocer-anchored properties. Many inline tenants within unanchored or strip retail properties are either closed for business, behind on rent, or both, which creates a problem for lenders to underwrite that rental income stream. Unfortunately, no financing is available for hotels, and most hotels have not begun to operate in a manner that can satisfy a debt service payment.

Adjusting the Rules of Refinancing


The Value of Budgets

One rarely discussed documentation subject is the need to prepare your budget and operating statements for refinance. Using third-party property managers may represent the best choice for commercial real estate owners, though many third-party commercial real estate property managers create budgets that are extremely conservative to ensure property managers hit their budgets. Unfortunately, this can negatively impact a lender's underwritten cash flow (and, consequently, the loan term) because most lenders assume an owner's budgets reflect optimistic assumptions. Any budgeted increase in expenses will be underwritten, and a lender may pause if revenue is budgeted to remain flat or down.

Another aspect that should be considered is the difference between an operating statement compiled by your accountant for tax purposes and an operating statement prepared for lending purposes. For example, an accountant may take a capitalized item, such as a roof replacement, and enter that as an expense rather than capitalize the expense and increase your carried basis. This is so you can take deductions for this year's taxable revenue rather than reduce capital gains if and when you sell your property in the future. While the lender wants to see all your repair and maintenance expenses, they will separately deduct a static replacement reserve from your net cash flow in addition to your R&M expenses. If capital items remain on your operating statements, the lender will be hitting you twice for capital expenditures.

Non-recurring or non-property related expenses should also be deducted from your operating statements. Again, from a tax perspective, you should include all the expenses your accountant advises you to include, but if there's a one-time legal expense or an upfront payment that will not recur in the future, you should deduct those expenses because the lender is only looking for recurring expenses.

Proving Damages

In terms of new documentation requirements, your lender will ask for documentation or evidence to help understand whether any of your tenants have been materially economically impacted by COVID-19 and the stay-at-home orders. One document is an aged receivables report. If your property has always had a portion of its tenants pay past the due date or even over 30 days late, it's important to show your lender a pre-COVID-19 aged receivables report and provide that perspective of your business. Also, some lenders may instinctively want to take an additional bad debt vacancy deduction for any tenants paying past their due date. Generally, there is a material difference between tenants paying after their due date (or even 30 days or later) and the percentage of tenants that ultimately do not pay.

Speak to your accountant and understand what percentage of late payers ultimately do not pay and gather evidence to present to the lender. The lender will also ask which tenants are currently open for business and whether any tenants have asked for rent relief or lease modifications. You must answer these (and all) questions honestly to avoid later triggering a “bad boy carveout” relating to fraud in the event of a future loan default.

Another way dirty laundry will be aired will be through the lender's strict requirement in reviewing tenant estoppels. Consequently, it is important to actively manage the needs of your tenants during COVID-19 and proactively come to positive resolutions with your tenants before commencing the refinance process to increase your likelihood of a successful loan closing.

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