Jump in Interest-Only Loans in CMBS Raises Caution Flag

Jump in Interest-Only Loans in CMBS Raises Caution Flag

"Leverage isn’t an issue. Loan structure has become an issue." -- Justin Bakst, Director of Capital Markets Analysis for CoStar.

CoStar analysts are tracking a little-considered data point that could suggest trouble on the horizon for commercial real estate. Owners of commercial real estate are carrying interest-only loans at a higher rate than they did right before the last recession. However, leverage levels on debt remain nowhere near the danger levels of 2007. But the preponderance of interest-only loans means owners could see increases in monthly debt payments right as the real estate performance of their properties - and cash flow - slows down. And for owners with maturing interest-only loans, the ability to refinance at the sub-3 percent interest rates of recent years is highly unlikely, as interest rates have already risen and are projected to continue. Either way, the situation could lead to an increase in commercial mortgage defaults, especially if fundamentals soften and property values slip. "Leverage isn’t an issue yet," said Justin Bakst, director of capital markets analysis for CoStar. He specializes in risk assessment, and expects an economic downturn in the coming years that will impact rents and lower property values. "Structure of loans has become an issue," he cautioned. According to CoStar analytics, a full 87 percent of loans in 2018 CMBS originations were either fully interest-only or partial interest-only. That is up from 73 percent in 2015 and the low of just 10 percent in 2009.

And while loans included in CMBS offerings make up just a tiny fraction of total commercial real estate loans, the trend is worth noting, analysts say, because the run-up to the last real estate crash followed a similar path - the percentage of interest-only loans went from a low of 15 percent in 2000 to a high of 79 percent in 2006, just before the market began to crater. Partial-interest only loans, under which borrowers begin to pay both interest and principal in the final years of the loan, are particularly vulnerable, noted Bakst. Kroll Bond Rating Agency warned in a recent report that the pressure could be building. "With rental rates exhibiting signs of slowing and even declines, [partial] IO loans could come under pressure just as their amortization periods kick in," reads the report from March. "This is noteworthy, as in the next 24 months, 64.9 percent, or $23.4 billion, of the outstanding [partial] IO loans from the 2013 to 2017 vintages that are still in their IO periods will begin to amortize." Larry Kay, a senior director at Kroll, echoes the concerns of others. "What we found in our default study is that partial-interest loans have a higher rate of default," he says. "In our view, we believe more of those properties will have an inability to meet that debt service." For the most part, lenders and various oversight agencies have been much more disciplined in their underwriting for commercial real estate, and today’s lower loan size-to-property value (LTV) mortgages mitigate the risk quite a bit, agreed Bakst and Kay. But other factors could exacerbate it. Big banks are slowly reducing the percentage of commercial real estate in their portfolios, according to CoStar research. Yields have dropped, making other investments as attractive as real estate has been. As smaller banks step in to finance construction and the acquisition of properties, their lending rules are often looser. Should smaller banks underwrite at higher LTV’s and add more interest-only loans to their portfolios, their exposure grows.

To plan ahead and have long term investment goals please contact Richard Murillo www.richardmrealestate.com (323) 209-8510

#WhatisaCommercialLeaseAgreement #realestatepractitioner #storagewarehouse #forsale #CommercialRealEstateLease #industrialrealestate #losangeles #sellrealestate #buyrealestate