Impacts of DSCR: Strain, Pain, When to Retain
With rates staying high, many borrowers are at a crossroads, writes Gantry's Ben Johnson.
The greatest challenge to securing financing in the current cycle is without a doubt meeting the necessary debt service coverage ratio in the current rate climate. Debt liquidity remains abundant, ready and accessible from a broad range of sources. However, while most lenders have not changed their DSCR requirements, rates have gone up substantially since 2022.
Recent downward movement of Treasury yields since the beginning of the year will help, but the ability for a property to adequately fund itself from operations in a higher-for-longer rate climate that has reset the market will still be a challenge in the year ahead. This reality will have an outsize impact on commercial properties valued at $15 million or less, as internal and external debt and equity resources for these owners are more constrained.
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While we haven’t seen many borrowers in the $15 million or below value range having to give back properties in the current cycle, we have seen growth in listing a property for sale while at the same time engaging debt sources for refinancing. The decision is ultimately dictated by which direction offers the best overall return for a sponsor borrower’s investment goals. Both strategies face challenges, but in the end, refinancing to hold is often the desired outcome and remains feasible even in the face of higher rates.
The refinancing route
Two years ago, when a borrower moved to refinance a property, putting cash into the asset was not a requirement or consideration that they would normally consider as part of the process. But over the past 18 months, that reality has changed dramatically. Borrowers faced with the prospect of refinancing a loan with a five-year term are taking debt that might have been based upon sub-1 percent Treasury yields and replacing it with a rate based on Treasury yields of over 4 percent. For borrowers in this position, the cost to refinance maturing debt will eat into net operating profit established at the lower rate—income which may or may not have grown enough during a loan term to meet the moment.
Many properties that are refinancing from 10-year debt placed in 2015 will be able to meet today’s DSCR levels and may still be able to achieve cash-out proceeds if operations have remained consistent and improved during that time, allowing for significant appreciation. Very few properties are still charging the same rents as they were in 2020, even as other operating costs have increased. However, cash-out proceeds may not be as easy to reach when underwriting a new loan at current DSCR capacity, and for many, a break-even refinance will be wiser than pushing up to maximum leverage.
Cash-in for a refinance transaction will most likely have to come from internal sources for assets in the sub-$15 million category. For any owner with enough liquidity on hand, expectations should include writing a check for as much as approximately 30 percent of the current loan balance, depending upon the property type. Since you won’t find as many preferred equity, participation or mezzanine funding solutions for investments in this range, there are other creative approaches to the cash-in conundrum. One strategy that is available is the cross-collateralization of assets performing at different levels to offset weakness in one through the strength of another, especially if the subject property is not operating at a stabilized level. In a similar approach, refinancing debt on an asset with leverage bandwidth to provide proceeds can identify funds to be deployed into other struggling properties worth saving for future upside.
Lastly, in limited instances, interest-only terms can provide breathing room for properties that need to extend leverage higher into the capital stack. While interest-only terms are much more readily available for multifamily properties, they do exist for other asset types when performance and DSCR bandwidth merits and still meet lender risk tolerance.
Investment sales
The reality of increased DSCR burdens will continue to have an impact on investment sales. However, as rate volatility settles into consistency at the current range, we should begin to see movement. For many borrowers dealing with maturities, the decision to hold or sell will be driven by the cost of debt. The stall in the asset sales market in 2023 and 2024 was driven by negative leverage and cap rates. While some negative-leverage transactions took place during that period, mainly due to 1031 exchange requirements, much of the potential transaction activity was halted, with owners holding assets and buyers keeping their capital sidelined. Price discovery ensued, pitting sellers seeking to maintain a past value from a different rate climate against buyers unable to accept a going-in cap rate under their interest rate. As maturities compel owners to either put cash in to refinance or sell at a value the market will bear, we are beginning to see going-in cap rates align with current interest rates. Price discovery this year will be compelling for owners and lenders, with distress most likely only appearing in lower-Class B to Class C properties.
Rate strategy potential
Volatility is real and has defined the challenges faced by most assets in the current rate cycle, excluding office, which is processing its own set of operating challenges. The MBA recently forecast the 10-year Treasury yield to range from the low to high 4s this year. We are currently in the lower range of that forecast, but that could change as the year progresses. If you can make a loan work at current pricing and have worked through the process of identifying a viable lending source, lock a rate now. If you have a pending maturity that is nearing or at prepayment thresholds, start the process today and take volatility out of the equation.
Ben Johnson is a director in the Seattle office of Gantry.
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