STATESIDE: The big pay-off

There’s no denying that interest rate hikes are a concern to many private equity real estate firms. But worries about borrowers’ abilities to refinance at a time when a massive wave of CMBS loans is set to mature may actually be overblown. In fact, an emerging trend indicates rising interest rates may be a blessing in disguise for certain property funds.

Two seemingly contradictory reports from commercial real estate data provider Trepp highlight this scenario. In June, the New York-based firm projected that the volume of maturing CMBS loans will surge from $79 billion in 2015 to $111 billion in both 2016 and 2017. Of the $330 billion in CMBS loans that are due to mature through the end of 2017, 10 percent to 20 percent could face refinancing challenges if interest rates were to increase by 150 basis points, according to the report. Rates are already higher than they were a year ago, and the Federal Reserve’s pullback of its economic stimulus is likely to cause them to rise even further, the report said. 

A Trepp report released last month, however, showed that the expectation of rising rates is actually helping to spur, not curb, some refinancing activity. The report pointed to a surge in defeasance volume over the past 18 months, nearly quadrupling from an average of $3.3 billion per year from 2009 to 2011 to $11.8 billion in 2013. 

Defeasance refers to a borrower paying off a loan that is currently locked out from prepayment, which usually applies to the first seven years of a loan. On average, a defeased mortgage had one-and-a-half to two years of prepayment lockout remaining at defeasance, according to Trepp. This early payoff of a loan is usually paid for with the sale of a property or refinancing, where a borrower either wants to lock in a lower rate or take cash out of the property. In such a situation, a borrower will pay its remaining interest payment to the lender through the purchase of Treasury bonds that would cover the remaining loan period.

What’s interesting about the defeasance trend is that an early pay-off of a loan typically is costly, and more expensive than other options such as hedging, where a borrower essentially buys insurance that interest rates will not go above a certain cap, or otherwise would be compensated; or prepayment, where a borrower pays a prepayment penalty to pay off its loan early after the lockout period ends. In all three cases, a borrower will pay upfront costs to avoid higher rates in the future, but these costs negatively affect investment returns. 

According to Joe Lewis, a director at JCRA Financial, for an investment with debt with a loan-to-value of 50 percent and a 2017 maturity date, the defeasance cost would be approximately 1.8x the annual net operating income of the deal, or $18 million. Meanwhile, the cost of hedging the 10-Year Treasury rate for three years would represent about 50 percent of the annual NOI, or $5 million, assuming an NOI of $10 million and a cap rate of five percent.

The uptick in defeasance volume, despite the high costs, has a lot to do with concerns about rising interest rates. The difference in rates between what a borrower would pay right now for a loan versus what it could pay for a loan in the future is considered sizable enough for some borrowers to justify the defeasance costs. Another motivating factor is the recovery in property values, which gives a borrower enough equity in an asset to pay off the loan early and cover the cost of defeasance. 

The early sale or refinancing of an asset, meanwhile, means a higher return on investment. While no specific data is available on defeasance within the private equity real estate industry, the fact that private equity accounts for approximately 20 to 25 percent of commercial real estate volume would indicate that they likewise make up a sizable portion of the defeasance activity. 

Financing costs, which include defeasance costs, are part of a fund’s operating costs, while its returns are based on revenues net of operating costs. The expectation in incurring defeasance costs upfront is saving on financing costs in the long run, which ultimately would boost returns.

This is particularly the case for funds that purchased properties in 2010, when values were at a low point in the wake of the global financial crisis. Such vehicles are likely to be driving much of the current selling and refinancing activity in the market, since the values of the properties purchased by those funds now have rebounded dramatically, allowing the vehicles to hit their hurdles much earlier than expected. “The return is really based on time,” said Gerard Sansosti, head of the debt placement group at HFF. “So the quicker you can hit your hurdle, the higher your yield is going to go up.”

It’s important to note that the current defeasance trend is partly the result of unusual circumstances, namely the sharp post-crisis appreciation in property values, which is unlikely to continue over the long term. But by locking in low interest rates at the same time, many private equity real estate firms are doing what they do best: capitalizing on an opportunity within a narrow window of time.