What About That “Other” SBA Loan?
Most people talk about SBA loans as if there’s only one, and that typically being the 7(a). The other equally useful in the right situation is the 504. This doesn’t get much exposure, probably because it’s more complex. I recently had the occasion to review a 504 with a borrower (my client) and a bank BDO. A brief overview of the loan is offered for orientation:
The 504 is really two loans packaged as one. (Now you begin to see why it can be confusing.) Both are backed by real estate – no business only acquisitions using this one. The 1st deed of trust (DOT) backed loan is really a conventional loan made by the bank. This typically to 50% of the total loan. The 2nd DOT-backed loan is made by the SBA through a Government chartered Certified Development Company (CDC). The SBA loan is actually funded by debentures (bonds) sold in the debt market – hence a market driven rate, not a legislated or statutory rate, e.g., the 7(a). The CDC 2nd funds (up to) 40% of the total loan amount. This leaves the borrowers equity-in to be 10% (or possibly higher). Depending on the use of proceeds (acquisition, construction, etc.) the allocations of participation may vary.
The rates for the two loans don’t have to be, and usually aren’t, equal. Other variables have to do with the term of the two loans and pre-payment penalties. In evaluating the rates you’ll hear the term ‘blended rate”. This is a blending or averaging of the two loans rates and amounts of money funded at each rate.
One of the attractions of 504s is the size of the loan that can be obtained. Not well known is that the SBA guarantee in the case of the 7(a), and the amount of the 2nd funded in the case of the 504 cannot exceed $5mm. However, if the 504 only uses 40% of the total loan amount, the total loan size can be as high as $12.5m.
The 504 can be used for acquisitions of existing businesses with real estate, or construction of new real estate. The loan has a construction (pre-existing development) component that can be used for the construction of a project and upon completion, rolled into the permanent loan.
Pre-funding ahead of the SBA issuance of the debenture is accomplished by a bridge loan from the lending bank. Because the debenture is funded in the future, the actual rate will be unknown until funding is complete. Market movements (volatility) during the bridge funding period in nominal, typically measured in basis points.
For rate-only comparisons today:
504 25-year debenture purchase rate (December’s auction): 3.64%
Lender’s 1st DOT rate: 4.5-4.75%
(The blended 504 rate is somewhere in between.)
7(a) rate: This loan is made by the lender (bank) at a rate not to exceed Prime + 2.75%. (SBA guideline).
Prime today is 4.75%. How much each particular loan is priced over Prime “depends”!!
Generally, if your project doesn’t exceed about $5.8mm (85% LTV of acquisition or construction), you’ll find a 7(a) easier to use, although with a higher rate, but more accommodating (managing) once on the books.) It’s also cleaner to analyze ahead of the decision.
Banks are Reverting to Old Bad Habits
Banks could be slipping into old bad habits. Last year, as interest rates fell, banks started to loosen underwriting standards reminiscent of the last cycle—the kinds of missteps that ultimately led to the great recession. This includes high loan-to-value ratios as well as skipping essential steps, like income verification – no-doc loans are back in the CRE lending market!
“The banks are starting to get a little bit scary. You are starting to see the behavior that you saw in 2006 and 2007 again,” says Steve Jacobs, CEO of Ten-X Commercial in an interview with GlobeSt.com”.
I don’t think this is a mainstream trend - yet, but it’s something that I’ve noticed recently. This ramps up buyer activity and compresses cap rates, pushing pricing up. This translates into a buyer maybe paying a 4-cap for a property when it really should be a 5-cap. This is when it gets dangerous. I’m told this dynamic is also present in the residential market, but at the commercial desk we only observe the residential market from a distance.
On the commercial side, I’m seeing lenders that were holding tight at the 60% or 65% loan to cost or loan to value starting to play in the 70% or 85% range, depending on the asset class and pre-construction vs. existing income-stable properties. I’ve seen lenders wonder aloud of 85-90% loans, but not seen anything actually close at these levels.
It is hard to say what is driving this trend—especially since the downfall of the last cycle wasn’t so long ago. It could be the reduction in interest rates, which made money cheap while demand remains high - it may stem from that. Generally as rates drop banks make less money; spreads get compressed. Lenders operating aggressively in low rate environments may be sacrificing profit for market share. If so, any one bank can’t conduct this strategy for long. This being the case, you may find significant rate spreads in funding offers. (Don’t forget to check all the other covenants in their proposal – ask questions.)
Low Interest Rates Spur More Refinancing Activity
Even more favorable rates have unleashed a fresh wave of refinancing activity during H2-19.
Borrowers have been enjoying a low interest rate environment for some time. Yet the Fed’s last 3 rate cuts in H2-19 have stoked a surge in refinancing activity.
The Federal Reserve kicked off the first of three rate cuts in late July, which subsequently pulled commercial real estate lending rates lower in the third quarter. Notably, the 10-year Treasury dropped by 50 basis points in August to a near cyclical record low of 1.47%. The favorable rates have unleashed a fresh wave of refinancing activity. Borrowers are paying off loans early to take advantage of the low rates.
For example, some of the 10-year loans that were done 7 years ago were done at 5.5 % or so, whereas borrowers now have an opportunity to refinance at sub-4%. So, the math on that is pretty simple, even if you factor in a small pre-payment penalty for an early exit.
The current refinancing activity is widespread across asset classes. For example, Fitch Ratings noted that the pace of defeasance on CMBS 2.0 loans surged following the July rate cut, with Q3-19 volume that totaled $3.92 billion. Overall, the 2019 defeasance volume for CMBS 2.0 deals through the third quarter was on par with the full-year 2018 activity at $10.9 billion.
Other data sources show a similar spike in activity. The Mortgage Bankers Association reported that the volume of commercial/multifamily mortgage originations in Q3 jumped 24% year-over-year, according to its most recent quarterly survey of commercial/multifamily mortgage originations. Research firm Real Capital Analytics reported an even higher increase on year-to-date refinancing transactions through the first three quarters that was up 63% year-over-year.
Spreads have narrowed. For example, there was a window in Q3 where some uncertainty on reaching lending caps caused Fannie and Freddie to widen spreads in order to slow lending volume. However, agency spreads have narrowed and, along with the Feds’ rate reduction, it remains a very low rate environment.
Current refinancing deals are offering more than just savings on lower rates. Borrowers are taking advantage of other benefits when refinancing deals. Some are shifting to non-recourse, moving out of short-term floating debt and into longer-term fixed-rate financing, or getting longer interest-only periods, which helps to drive cash flow and returns.
Many owners are also using refinancing as a means to pull equity out of a property in cases where values have increased. That strategy has become a popular alternative to selling assets in the current market, where it has become more challenging to redeploy capital into new real estate investments.
If you’re sitting on an asset and you don’t intend to sell, it’s an opportune time to term-out at more attractive financing. Debt markets also appear to be marking properties at higher valuations than an owner could get in the sale market, so there is somewhat of an arbitrage there with a cash-out refi,” he says.
In addition to the low rates, borrowers are continuing to enjoy a highly competitive lending market where lenders are working hard to retain or win refi business with both economic and non-economic terms.
The downside of the recent flurry of activity is that it’s likely pulled some refinance business forward into 2019. Potentially, the loans being refinanced then could result in a thinner pipeline of deals next year, 2020. However, it is difficult to say what the net affect might be on origination activity in 2020. Certainly, there are other drivers of demand, such as acquisitions and construction activity, which could remain robust and contribute to strong overall lending volumes in the coming year.
COMMERCIAL REAL ESTATE (CRE) FINANCING & FED POLICY
The Federal Reserve’s recent interest rate cuts have sent a surge of excitement through the commercial real estate (CRE) market. Fed influenced rates have returned to 2018 lows, however, the Fed’s interest rate reductions have little to do with conventional CRE financing activity because most conventional commercial real estate lending is indexed over the 5 & 10 year Treasuries. The exception being SBA 7(a) loans that are indexed to the Prime rate which is normally set within a fixed spread vs. the Fed Funds Rate.
Treasury bills, notes & bonds are global instruments affected by worldwide geopolitical events, not necessarily United States monetary policy, i.e., a legislated rate. The recent spreads range from a low of 1.6% to 2.50% for most CRE properties and continues upward above 2.50% based on the risk profile of the property and the borrower, and other covenants of the loan.
Financing activity is tied to these factors, which have put recent rates in a range of 3.5% to 4.5%. This is still considered an attractive cost of capital, and in most cases provides positive leverage. For example, a not-too-exciting run-of-mill $5mm CRE investment with an initial NOI of 6%, that is leveraged 60% ($2mm/40% equity and $3mm/60% debt) borrowed at 4% interest, has a 6% return on investment (ROI), but as leveraged, has a 9% return on equity (ROE) … a yield enhancement of 50% over the unleveraged acquisition.
With more than sufficient liquidity in the market and strong CRE fundamentals, the now 10-year cycle in the CRE market looks like it has more room to run. But the Fed’s drop in interest rates is probably more of a psychological boost to financing. The capital markets are where to look for clues to the future – what are lenders doing. Keep an eye on the bond market. This market has led less transparent markets by as much as a couple years. The bond market will give you insight into the medium and long term cost of capital (5-20 years for CRE). The Fed largely influences the short end – 2 years and less. When they get out of sync with the public markets, e.g., an inverted yield curve, pay attention. How this resolves to “normal” is significant. Which party blinks first, the Fed or the bond market.
The CRE investment opportunities are apparent; the financing opportunities perhaps less so.
VARIABLE RATE LOANS AND FED POLICY
Reminder from our last issue:
You’ve heard of ZIRP – zero interest rate policy – from 2008-2015. Now get ready for NIRP – negative interest rate policy. Currently about $16 trillion of sovereign bonds (all countries that issue), or 25% of the total outstanding, trade at negative interest rates. This trend is firmly in place and increasing. The investor is paying the issuing country for the privilege of lending them money, or seen a different way, the investor has locked in a guaranteed loss if the bond is held to maturity. This is Alice in Wonderland monetary policy. Will Jay Powell turn out to be the least insane man in the asylum? And what does this mean to us in the CRE borrowing business? How might we expect this trend to color our borrowing potential going outbound?
Assuming Powell follows through with rate-reduction madness (they just reduced rates again today), how far down the rabbit hole will lenders go in following the Fed? For conventional loans we don’t know. However for Government guaranteed loans the Treasury will see that funds remain available. That’s fine for residential loans – FHA & equivalents – but how about CRE loans with businesses … especially with businesses. (Small businesses create jobs, and our Government is all about creating and retaining jobs. Sub-4% unemployment is good at election time.)
This sounds like an SBA loan … it is an SBA loan!! A type 7(a) to be specific.
There are 2 characteristics of this type of loan that are notable at this time.
1. The rate is variable (with only a few lender exceptions that I suspect will fade away in the current rate-declining environment). The rate will adjust up or down with changes in the Prime rate. In our current lending environment this is good. We think rates are low now, and historically they are, but we’re pioneering new ground on our way back to ZIRP, and possibly NIRP. We suggest you not want to lock in the low fixed rates that are being promoted by lenders.
2. More flexibility. Borrower’s go nuts when they hear the term is 25 years fully amortized. How can I possibly forecast 25 years in this highly charged rate environment? After all, the Fed is only one step removed from the Government and fiscal policy … that’s 6 election cycles! Well here’s the good news that almost always falls through the crack. The pre-payment penalty schedule for a 7(a) is 5, 3, 1, then zero!! That’s 5% in year one, 3% in year 2 and 1% in year 3, then zero for the next 22 years! After 3 years there is no pre-payment penalty. From a re-financing standpoint this looks a lot like a 3 year bridge loan with built-in extensions for the next 22 years, and without the up-front and back-end points (SBA guarantee fee notwithstanding).
If rates are indeed going to bottom over the next few years, refi your loan then and lock in that fixed rate in the lower interest rate environment that will exist. (I don’t expect you’ll get a ZIRP loan, but you never know.)
WHY AN INVERTED YIELD CURVE IS GOOD FOR FINANCING CRE
The black economic cloud that is typically associated with an inverted yield curve does indeed have a silver lining.
The table below shows selected U.S. Treasury rates as of Oct. 1, 2019. Rates look essentially flat from 1 month to 1 year, then take a noticable dip for years 3-10. and start to climb (normalize) from 10 to 30 years. Longer term rates don't exceed the 1 month rate until almost 20 years, and then by only 14 bps in year 20. Notable the 30 year rate is only 32 bps higher than the 1 month rate.. As an investor, going out a full 30 years would only get you only those few bps (basis points) more than buying a 30-day T-Bill. Buy we’re not considering the investment side of this; we’re looking at this as borrowers.
As of 1 mo. 6 mo. 1 yr. 3 yrs. 5 yrs. 10 yrs. 20 yrs. 30 yrs.
10-19 1.79 1.82 1.73 1.51 1.51 1.65 1.93 2.11
Among all the credit markets there tends historically to be correlations among the various types of debt instruments. The correlations are not exactly 1:1, but they maintain their linkages within fairly predictable ranges, in spite of the Feds intermediation the last decade. CRE debt operates within this atmosphere.
CRE lenders, be they banks, hedge funds, insurance companies, ESAs, etc. take their cues from their cost of money, alternative investment vehicles, creditworthiness of the borrower, geographical location, asset class, and a few other parameters. Borrowers traditionally pay a higher rate (cost of money) for the longer the term of the loan. At this time, however, longer terms have a lesser rate with the lowest rate in the 3- 5 yr. period, and longer term Treasuries don’t surpass the 30-day Bill until about the 20th yr.
If you’re considering a conventional CRE loan in the 5-10 yr. maturity range, you should expect to find tight spreads for rates, all other terms being equal (which they never are). This suggests you can borrow longer term for a nominal incremental rate. What’s the cost to renew a 5-yr. loan at the end of the primary term? … a point? Today the difference between the 5 yr. and 10 yr. is about 15 basis points. You can extend that 5 yr. loan today for a successive 5 yr. period (a 10 yr. term) for less than a ¼ of a point, and no re-application cost or hassle. Lenders will offer products up and down the maturity line as a function of the parameters mentioned above, in addition to keeping an eye on the competition.
There’s currently an excess of liquidity in the debt markets, particularly among the non-bank lenders not subject to banking regulatory rules. Late in the market cycle borrowers are cautious about taking on new debt. This creates a supply-demand imbalance in the borrower’s favor. Lenders will structure products (loans) to fit the current curve, promoting the shorter term maturities with fixed rates, and longer term offerings leaning toward variable or adjustable rates, the exception being Government guaranteed loans. Longer term fixed rate loans in this environment may be hard to come by – at what point will banks start to pull commitments because their spread goes to zero? Other terms and conditions may come into play compensate the lender for anticipated curve normalization over the term of the loan – be sure you read all the terms of the loan, not just the rate and maturity.
Be sure you consider private money sources, too. They can be more aggressive/competitive in “unusual” environments like the one we have now, and possibly will have for the next year or so (or more?).
SO MUCH NEWS, BUT SO LITTLE CHANGES
We’ve endured the endless bombarding of “up-to-the–minute” news, “news-alerts”, and “this just in” for what seems like, dare I say, forever! And this doesn’t even include the onslaughts to those of you who stay glued to your hand-held devices for the never-ending tweets and hashtags. And the hot topics of the days gone by remain: trade tariffs, inverted yield curves, not if, but now when the next recession will hit, speculation about the Fed’s policies and whether the next FMOC meeting will raise, lower or hold pat on the Fed Funds Rate. The response of markets adjusting to the next shoe that drops seems instantaneous.
So many dots … how to connect them given that they keep changing? Unless you’re a 10-minute trader on E-Trade, you don’t. But clearly the news cycles have become opioids for the markets, this reflective most easily by considering the extreme volatility.
The volatility seen in public financial markets reemphasizes the security of CRE (commercial real estate). The recent financial market swings reiterate both the stability of commercial real estate and the attractive debt yields offered by this asset class. In addition, the exceptionally low interest rates currently available provide a highly-levered yield premium on a risk-adjusted basis for CRE. The recent average combined CRE cap rate of 6.3% exceeded the 10-year Treasury by 480 basis points (4.8%), one of the widest margins this cycle. Key to obtaining CRE enhanced by leverage is the financing used.
Current CRE investors look at declining interest rates with one eye, and their current loans with the other, anticipating refinancing when the current declining cycle bottoms … “then I’ll do it!” they say. This was the case in 2007 & ’08 when the Fed started us down the road to ZIRP. Some of you may remember. But borrowers also need to keep a 3rd eye on lenders. A funny thing happens when rates decline, especially if rapidly. (This typically in a recessionary environment, whether formally called or not.) As the economy weakens and rates keep dropping, banks are busy raising the bar on their underwriting standards! When rates get so low that you can’t wait to refi, you find that banks (and other lenders) have essentially stopped lending!! Banks especially may advertise “low” rates, perhaps 2-3%. And applications may come pouring in, but sadly no body qualifies! Now you’re stuck with that now-high-priced older loan at the bottom of the cycle until the economy recovers and the interest rate cycle clicks up again.
There isn’t exactly frantic lending yet, but the movement is afoot to get loans out the door before then next ¼ point (or ½ ?) rate drop. Declining and low interest rates also eat into banks margins. You may think rates are low, but banks can tell how low by the spreads. If the spread on any particular type of loan gets too thin, the lender will discontinue that loan. When the lending market went illiquid in 2009 it wasn’t because there was no money available. The Fed had been flooding banks with money through the various QE programs. The banks simply cycled the money (quietly) back to the Fed in excess reserves – no loans were made, and the economic recovery languished. The banks couldn’t afford to lend in the poor economic environment at the low-to-no spreads at the time. Hence the recovery waned. (Too bad it took the Fed several years with variations of the theme to figure this out. Maybe they’ll do better next time … but it’s still the same Fed!)
There’s a saying in markets that nobody sells the top, or buys the bottom … it’s just a saying. But the same can be said for refinancing a loan. Generally speaking, if you can make an incremental improvement in the debt component of your investment that otherwise makes sense, you should look at that pretty hard. The nature of the improvement may be quantitative or qualitative, and the acceptable level of incremental improvement is a judgement call. Bear in mind also that the rate is only one of the many terms and conditions of a CRE mortgage. Be sure you consider ALL the covenants.
THE FED IS JUST THE TIP
By the time the ink dries on this BLOG, if the futures market is correct the Fed will have reduced interest rates (the Fed Funds rate actually), by ¼ point. (It’s giving a quarter-point drop today a 100% probability.) Perhaps a better question isn’t when will they drop or raise the rate again, or by how much, but rather why will they do either, or consciously decide to do nothing.
The by-now-well-known (accepted) reason is to support the stock market, of course. But that’s old hat – everybody knows that, and as such there’s no particular advantage to any one investor. (Incidentally, nothing in the Congressional Act authorizing the creation & mandate of the Fed is support of the stock market mentioned.) But that doesn’t concern you … you’re reading this for information and insight into managing your CRE (commercial real estate) financing … perhaps to finance a new acquisition, refinance an existing property, or do a sale-leaseback in lieu of conventional financing.
So let’s consider the economic cycle, for this by their own admission is what the tea leaf readers at the Fed take their cues from to set and execute policy. Standard thinking is: weak economy => rate cuts => economic stimulus => rising GDP and a stronger economy. But there’s some untimeliness afoot when connecting these dots with CRE and CRE financing. It’s not that they’re unrelated, but they’re asynchronous – some would say random. The unreliable element is timing, that serendipity variable we all try to get a handle on but never seem to be able to. I yield to one of my favorite philosophers who waxed poetic on the subject:
“I find it very difficult to make predictions, especially about the future.”
(Not familiar with Yogi? Try Googling him. He’s of sufficient fame that you’ll find several hits for him.)
But more to the point - let’s draw some relationships.
The value of CRE is primarily determined by its income stream.
The value of CRE is often (and simply) gauged by the “cap rate”, i.e., the income stream in dollars expressed as a percent of the value (price). This is an inverse relationship, i.e., if the interest rates go down, and income (NOI – net operating income) remains the same, the price goes up, and vise-versa.
But let’s consider why the the Fed may be dropping rates that ¼ point. Ostensibly this is to support a slowing economy and perhaps, they hope, prevent a recession. If the economy weakens as expected, however, we might expect business to slow down, CRE vacancies may be expected to increase, meaning that the net income to the property owner should be expected to decrease. And if rent decreases shouldn’t the property value go down? Of course. But wait … how can the value of the property go up because rates and reduced, but also go down because income decreases? The answer, of course, is the timing of the movements. But which comes first, the price movement or the interest rate movement? Experienced investors will tell us price moves first in reaction to lower rates. Experienced tenants, however, will tell us rents move first in anticipation of a slowing economy.
Unlike the stock market which is immediately transparent for all to see, the CRE and financing markets are much more opaque. This lack of immediate transparency causes the delays in movement between relationships. And the delays themselves cause misinformation, interpretation of information, speculation, false steps along the decision path, and unfortunately some bad decisions.
So how do you, the CRE investor/landlord/finance manager, track this information and divine the future to know where you are at any point in time so as to make accurate, foresightful, and yes, timely decisions?
Yes, the Fed is just the tip. It’s what’s downstream that causes our consternation.
Financing the Retail Asset
From a financing perspective, the retail sector continues to be challenged, but there are good gems to be acquired too.
From a lender’s perspective, there are particular challenges to retail deals getting done:
All of these issues can have significant impact on leverage levels, pricing, and whether or not a deal can even garner interest from a lender.
And who’s the culprit threatening retail? Why e-Commerce, of course.
However, in the CRE (commercial real estate) finance community one size definitely does not fit all. Opportunistic lenders are seeing an increased flow of opportunities since they require a creative and entrepreneurial lens.
Tenant mix, strategic plans for maintenance or repositioning, the leverage level, and the strength of the sponsorship is very important. Lenders need to understand and underwrite the story for success. The right tenant mix today typically is a mixture of food service (restaurants), entertainment and services … those services that can’t be ordered and shipped by Amazon, et al, more commonly termed “e-commerce resistant”. The retail center is starting to look a little like office services, just as the industrial park is beginning to resemble some retail. As the lines blur lenders are adjusting underwriting parameters.
The disruption caused by technology has increased the risk of hanging on to old business/investment models, but has also created opportunities for creative investors and problem solvers. These investor/borrowers are best served by aligning with equally risk tolerant lenders for successful acquisition and refinancing. This, however, is a decidedly smaller pool than it was even a few years ago.
So What Have You Done Lately?
We had a qualified borrower with all the qualifications lenders look for in a borrower.
The challenge: finding a lender for a conventional owner-occupied property that would refinance a gas station (not a popular asset class) and cash out the borrower up to 70% LTV … in this case $1,000,000.
BANKS ARE EXPECTING A STRONG YEAR (2019) FOR CRE LENDING
The Mortgage Bankers Association (MBA) recently reported another stellar year for commercial/multifamily mortgage originations in 2018. Although the MBA will release final data next month, results from its fourth quarter mortgage originations survey point to volume that could be 3% higher than the record $530 million reached in 2017.
Banks are facing more competition. Growth of non-bank lenders has added a whole new dimension to the competitive landscape, particularly in bridge and construction financing, notes Kathleen Farrell, executive vice president, line of business executive, commercial real estate, at SunTrust Banks. There are multiple bids on any opportunity or new project that needs construction financing. According to the MBA, GSEs and life companies increased loan originations by 16 percent and 10 percent respectively in 2018. Debt funds also saw a big jump of 29 percent from an estimated $52 billion in 2017 to $67 billion in 2018.
Counsel Mortgage Note: If you’re only looking at banks for your CRE mortgage financing, you’re limiting your market search. Bank lending actually took a drop of 10% in origination volume last year, while life insurance companies and debt funds increased volume 10% and 29% respectively.
Banks were riding good momentum coming into 2019, with Q4-18 mortgage originations up 5% year-over-year, according to the MBA. Although that increase is lower than the broader market, which saw an estimated 14% jump in mortgage originations during the last three months of 2018.
The core property types that are most in demand continue to be multifamily and industrial, followed by office, hotels and then retail. However, banks are exhibiting caution even for favored property types in markets that have seen high levels of construction. Lenders are drilling down to look at specific submarkets and micro-markets to determine if there are concerns about oversupply. Community and regional banks remain very active in commercial real estate lending; in some cases, more active than some of the national banks. In addition, community and regional banks are stepping out and doing larger and larger deals in terms of loan amounts.
One important backdrop for the current bank lending climate is that bank commercial and multifamily loans continue to perform extremely well. The delinquency rate for those bank loans that are 90+ days past due is near record a low of 0f .48 % as of Q3-18. Banks historically have had “measured confidence” about lending as long as their delinquency rate remained low, although to my mind this is like driving forward looking in the rear view mirror.
One of the notable trends to watch in the banking sector is that some banks are doing more long-term, fixed rate loans with 7 or 10-year terms for clients on a select basis. For example, SunTrust Banks started developing a permanent loan product about two years ago. SunTrust’s longer term fixed-rate loan product started to gain momentum in 2018, as interest rates began to rise. We might expect, however, that the Fed’s announced “patience” in continuing it’s previously announced 2019 rate increases will likely trigger a shift in borrower demand back to variable rate loans.
Looking ahead to 2019, banks could face more headwinds in construction financing due to the late stage of the cycle and rising costs. Banks have been pretty disciplined this cycle in maintaining their underwriting standards when they evaluate construction loans. As the cycle runs this year into 2020, expect underwriting criteria for construction projects to become more strict and covenants more demanding.
On the positive side, however, there is still a lot of equity targeting CRE and what appears to be a steady transaction pipeline that will require financing.
Money Center Banks Cutting Back in 2019
The nation’s largest banks are being more cautious with their commercial real estate lending, based on what they are saying on their earnings conference calls.
The same headwinds that slowed bank lending last year are extending into 2019, as economists debate how much longer the current economic expansion, on pace to reach a record stretch in July unless the effects of the government shutdown stop it sooner, can continue. Interest rates are projected to keep going up and institutions face stiff competition for deals from non-bank lenders.
Additionally, borrowers are prepaying loans sooner as properties trade hands, slowing the growth of loans on bank books.
Marianne Lake, CFO at JPMorgan Chase & Co., reported commercial real estate loans were up 2% in the Q4-18, less than its recent pace of about 3.9%, according to data from the FDIC. That was below the industry average of 4.5%.
“In mature markets we’re again being pretty prudent,” Lake said. “I won’t call it tightening, but being very selective.”
Lake added the bank is “tightening” construction lending.
Wells Fargo gave a similar outlook as JPMorgan for 2019.
The Federal Reserve Board’s latest Beige Book, an anecdotal look at conditions around the country, suggests a better lending outlook from smaller banks, which reported steady demand for commercial mortgages.
Commercial real estate loan losses are still minimal, as underlying fundamentals remain strong.
The Mortgage Bankers Association is reporting it expects another strong year of loan originations.
“Mortgage bankers look to 2019 as another strong year for the commercial and multifamily mortgage markets,” said Jamie Woodwell, MBA’s vice president of research and economics. “The majority of top firms expect that ‘strong’ appetites from both lenders and borrowers will drive commercial mortgage originations higher.”
Mixed messages? To be sure. If the top 2 mortgage lenders reduce their appetites for CRE mortgage lending, that leaves a notably large gap to fill to meet demand. Smaller banks, be they community or regional, are more niche oriented than the larger money center banks who address the market with a broader brush. We all know WF, BofA and Chase, but who knows the Bank of Hemet and what their sweet spot is? (besides Counsel Mortgage) Competition will heat up for the remaining players in the market, and terms and conditions will have more “live fields”.
It’s shaping up to be a hectic year, but that can also mean profitability for those who can navigate the terrain. Markets hate uncertainty – it forces many participants to the sidelines. And in the meantime opportunities pass. If you’re going to stay in the game, we suggest you not go it alone. Find a skilled and trusted ally who will work in your interests, not the lenders. If this is you, we suggest you give us a call.
When considering financing of a gas station, it's important to recognize whether you're financing a business, the real estate, or both. If you're buying an operating gas station business in Arizona, you'll likely find both the business and real estate being offered for sale - the real estate will look like an asset of the business. If you want to buy the business with the real estate, this will greatly enhance your ability to obtain financing. Enhance because the real estate provides valuable collateral that lenders prefer - 1 of the other C's.
For buyers of gas station businesses with the real estate, there are still only 3 sources of capital: the buyer's own equity (an all-cash buyer), the seller (known as a seller carryback), and an SBA loan. The seller carryback is the easiest to structure, most flexible for possible terms, and least attractive to the seller resulting in either a higher price being paid for the business, a higher rate of interest being charged that an SBA loan, or both.
For gas station financing, SBA loans come in two varieties, a 7(a) and a 504. For financing the business and the real estate, either a 504 or the 7(a) is available, or they may be used in combination. The complete particulars of each loan, how they compare, and which may be best for any particular situation is left to individual discussion. Contact us if you'd like further information. A few easy points of distinction and application: The 504 loan is really 2 loans, 1 made by the SBA directly, and 1 by a bank. The percent of down payment for a 504 on a special use property, e.g., a gas station, is typically 15%. The amortization period for the SBA's portion of a 504 loan is typically 20 years, but can be 10. For a 7(a) where the business includes the real estate, the amortization period is 25 years. Both the 504 and the 7(a) have specific qualified use of proceeds, i.e., what can be financed with each type of loan. In either case, the borrower's experience in the gas station business is still a critical fact; adding real estate as collateral doesn't mitigate this risk in an operator. If this applies to you, call us for preliminary discussion. One thing to note about SBA lenders, either bank or non-bank lenders: they tend to specialize, or favor, either the 7(a) or the 504. They can usually do both - they just choose not to. If the Business Development Officer, Loan Officer, or Relationship Manager (all the same function, just different titles), work directly for the lender and not a broker, it's unlikely you'll be offered both types of loans.
How large a loan can you get? The current ceiling for both 7(a)s and 504s is $5,000,000 in each case. These can be combined for up to $10,000,000. Also, they are not limited for use on just 1 property and/or business Theoretically, you can build your gas station portfolio with SBA loans, if you do it right.
A note on SBA guidelines. SBA guidelines are reviewed an amended as-needed annually as part of the Congressional budgeting process. The SBA is funded annually for it's allocation of loans and guarantees. Meaning the $5,000,000 limit is subject to change, as are the other parameters. For SBA loans, even though there is the Government's involvement, lenders have discretion in what loans they'll approve. An applicant can meet all the guidelines (parameters) required and still be declined by a lender. The subjectivity among lenders is what separates them in the market - not all SBA lenders are made equal !! This is particularly notable when attempting to finance a gas station. Gas stations have always been a challenge for financing, even before 2008. Some lenders just aren't comfortable with them !! Since lending resumed about 2010 there's been a constant turnover in lender interest for gas station financing. What they like today they don't like tomorrow, and who didn't like gas stations today love them tomorrow. This constant fickleness of lenders has been a continuing challenge to those of us who cater to gas station buyers, sellers, and borrowers. At MJG through Counsel Mortgage, we are constantly updating and expanding our resource pool of gas station lenders, and generally keep a short list of active lenders for our clients.
Buyers of a gas station business and real estate can also use conventional financing. Just recognize that conventional real estate financing will not apply to the business component of the valuation. In this case, the leverage is reduced dramatically. For example: a $1,000,000 gas station that values the business at $300,000 and the real estate at $700,000 will qualify for conventional financing of $455,000 (65% of $700,000). The remaining 35% of the real estate value plus the total amount of the business value will have to come from other sources, typically cash from the buyer, or a seller carryback.
This financing overview will give you a peak into affordability - the feasibility of buying a gas station. For all the gas station businesses we represent we have developed a Financing Feasibility model based on the individual businesses historical financial performance. These are available for your consideration as a qualified buyer - just ask.
Buying a Gas Station Business Only - Not Including the Real Estate
When considering financing of a gas station, it's important to recognize whether you're financing a business, the real estate, or both. If you're buying an operating gas station business in Arizona, you'll likely find both the business and real estate being offered for sale - the real estate will look like an asset of the business. If you want to buy the business only, planning on being a tenant of a lease, this will greatly affect your ability to obtain financing.
For buyers of gas station businesses only (will be a tenant to the real estate owner), there are 3 sources of capital: the buyer's own equity (an all-cash buyer), the seller (known as a seller carryback), and an SBA loan. The seller carryback is the easiest to structure, most flexible for possible terms, and least attractive to the seller resulting in either a higher price being paid for the business, a higher rate of interest being charged that an SBA loan, or both.
For gas station financing, SBA loans come in two varieties, a 7(a) and a 504. For the business-only loan, the 7(a) is what will be used. Plan on having 20-25% down, and a term of 10 years. Depending on the business historical profile and the borrower's history and credit profile, we've seen deals done with as little as 15% down, or seen the other way, I've seen them as high as 30%. The 10 year term will require a minimum of 10 years on the lease. It's important to note that the loan is made by a bank, not the SBA. The SBA only guarantees the loan in case of default. For this guarantee the SBA charges a guarantee fee at loan funding (close of escrow), The guarantee fee ranges between 2.5 and 3.5% of proceeds, and can be financed along with the cost of inventory and closing costs. One thing often not considered: the borrower's experience in the gas station business. This has become a deal-breaker with a lot of lenders. We've found some ways with particular lenders to compensate for this. If this applies to you, call us for preliminary discussion. A financing overview will give you a peak into affordability - the feasibility of buying a gas station. For all the gas station businesses we represent we have developed a Financing Feasibility model based on the individual businesses historical financial performance. These are available for your consideration as a qualified buyer - just ask.
Collateral for SBA Loans
I ocassionaly hear surprises that rapidly turn into complaints about a lender for an SBA 7(a) loan wanting additional collateral (property) for a loan they have pending. This has only surfaced recently as the prices buyers have been willing to pay have been increasing and are leading the values that appraisers are coming in with - somewhat typical in a recovering real estate market. (Bear in mind that appraisers took a big credibility hit in the 2008-2009 real estate collapse.)
The general SBA requirement is that the bank takes as collateral anything that is being financed. In the case of a business that includes the real estate, that includes the FF&E and inventory. If the value of the acquiring collateral does not cover the loan, the loan is still eligible. If the loan is considered under collateralized, however, and there is additional collateral available, the additional collateral must be used to secure further the loan. The "other collateral" typically means real estate with greater than 25% equity that is owned 100% by a guarantor. Whenever it's available, the lender looks first for the borrower's home.
Remember that SBA guidelines are just that ... guidelines. Some guidelines are more stringent that others, and some lenders hold them to be more conservative or aggressive that other. Collateral is just one of several guidelines that lenders consider with more or less flexibility in competing for loan placement. Most borrowers view all lenders through the same looking glass - this is a mistake. Also, many borrowers I deal with have the belief that lender's are doing them a favor by offering them a loan - also a mistake. Lenders complete for your loan. In lending on special use, or single use, properties such as gas stations, there are relatively few lenders who know the specific businesses such that they can be very aggressive in completing for the loan. If a broker intermediates the loan, they also have to be knowlegable about not only the business being financed, but the lending business also.
At MJG not only are we real estate and business brokers, but both Lynda and Mike are Commercial Loan Officers (BDOs) for the Counsel Mortgage Gp., with all that capability focused on gas stations and c-stores as a specialty. A recent count of identified SBA lenders with gas station capability tallied 50 lenders. Notably, only 27 are in AZ! The stress on lenders since the 2008 bank bailouts, and the additional extreme (in our opinion) regulatory burden placed on the industry by the Dodd-Frank law has caused terrific disruption to the lending business, and in turn for borrowers trying to identify a lender and negotiate a loan. It's also place a companion burden on lenders trying to determine what exactly is a qualified borrower today - and "today" changes almost daily! Out of our current inventory of 50 SBA lenders we keep an active short list of 6-8 lenders known to be currently making gas station loans. We are in contact with these lenders frequently and are constantly updating our short list.
Financing has been a critical element of real estate for longer than most of us can remember. Much of the credit and financing industry we operate with today came with the creation of the Federal Reserve System in 1911. Evolving immediately thereafter on the heels of WWI and the fiasco that was the Treaty of Versailles, which spawned the seeds of WWII, and subsequently the Bretton Woods accords, following up with the advent of fiat currency, we now live in a global economic, finance, and investment environment totally dependent on credit and financing to keep the wheels of progress rolling.
Have you ever thought about where the word "credit" comes from? (Probably not.) The term has it's roots in Latin, French and Italian words meaning "belief" or trust". Way back when, as long as your creditors trusted you, and believed you had the willingness and capability to pay them back, you were fine. The price you paid - interest rate - was a judgment about your willingness and capability to repay the loan. For instance: The Pilgrims borrowed $7,000 dollars (actually pounds) in 1620 from an investor group in London to come to the New World. They paid it back over the next 23 years at a rate of 43% ... the price of perceived risk.
Lenders still use this willingness to repay as one of the 5 C's, character, in underwriting loans. We've come a long way since 1620 ... we've added 4 more C's !
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This was a refi loan of 2 existing gas stations with convenience stores in the Phoenix metro market. Underwritten as a portfolio loan, but structured as 2 separate loans.
The loan was conventional and refinanced 2 existing SBA 7(a) loans. The refinancing released about $2.3mm of SBA capacity to be re-used for additional acquisitions. Combined loan amount was approximately $3.2mm, and included about $1mm cash out to the borrower.
LTV was about 70% with an interest rate in the low 5’s.
This was a strategic refinancing that allowed the borrower to reduce his debt service, liquefy an additional $1mm for cash down payments on additional acquisitions to expand his business, and position high-leverage financing for the acquisitions in the form of new SBA loans.
DISCLOSURE: Both Michael Green and Lynda Gromek are Commercial Loan Officers with theCounsel Mortgage Group LLC, 8700 E. Pinnacle Peak Rd., Ste. 224, Scottsdale AZ 85255. Arizona Lic. # MB0909580. To learn more about the Counsel Mortgage Group and services offered, Click Here. NOTE: When you "Click Here" you will be leaving the MJG Gas Station Specialists website and going to the Counsel Mortgage website.
COUNSEL MORTGAGE ANNOUNCEMENT
We're pleased to announce that Counsel Mortgage is now (effective 2015) licensed in California for the origination of both residential and commercial mortgage loans. Requests to or through MJGfor residential mortgages will be referred to a licensed residential originator at Counsel Mortgage - Counsel Mortgage Loan Officers who are also AZ real estate licensees will work only with commercial mortgages. See EZ click to Counsel Mortgage website, below.
(CA DBO# 60DBO43873; CA MLO# CA-DBO179539)