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Strange Days, Sleepless Nights
by Mark Levine
A friend recently asked me if she should refinance the debt on the small apartment building she owns in South San Francisco. I laughed and responded, “I think you mean, ‘Can I refinance the debt on my apartment building?’”
Unfortunately, these days the borrower is not in the driver’s seat. Well, actually, that’s an understatement. In most cases, nobody is in the driver’s seat because there isn’t even a car to drive. Usually we talk about a market leaning one way or the other, essentially being a buyer’s market or a seller’s market. In real-estate finance terms, that translates to a borrower’s market or a lender’s market. However, during the unique time in which we find ourselves these days, what happens when there’s essentially no market at all?
Before we delve into it, let’s first directly answer my friend’s question, because it’s really a quick and easy answer: yes. Or, if you want to be more helpful, the answer is: “Yes, and stop wasting your time talking to me when you could be refinancing your loan.” But this response makes a major assumption, and unfortunately it’s probably a bad one. It goes back to the assumption that my friend actually has the ability to refinance her mortgage. If she does have that option, she should jump on it.
So, for a moment, let’s suspend our disbelief and work under the assumption that there really is a choice to be made here. Why should someone take advantage of that option right now? First, and probably most obvious, is the fact that interest rates are still very low. We used to say that they were at “historic lows,” however I’m not sure that we can continue to use that term when something seemingly historic occurs every day. Hyperbole aside, rates are very low.
I am a big fan of charts. They give enormous amounts of information in a simple, easy-to-understand picture. For example, a 5-year chart of the 10-year U.S. Treasury Note tells you that, from 2004 through late 2007, the rate hovered between approximately 4% and 5%. Then there was a dramatic drop through the 4% line at the beginning of 2008, and the rate even touched below 3.5% for a few weeks in March 2008. In late 2008, the period known as “post-Lehman” among finance geeks, the rate dropped off of a cliff and hit sub-2.5% levels for a brief period. Since then, they have been steadily rising toward, and slightly above, the 3% level.
The point is that we are currently in a very low interest-rate environment, compared to recent history. But what about not-so-recent history? Let’s expand the chart back to 1999 and see where we stand compared to the last decade. We see quickly that there’s no contest. From early 1999 through the middle of the last decade, the 10-year Treasury rate generally hovered in the 5% range. Should we go back 20 years? That makes today’s rates appear even lower, as the late 1980s and early 1990s were characterized by Treasury rates above 6% and generally closer to 8% and even 9%. We won’t even discuss the 14% Treasury rates of the early 1980s.
You get the picture. In order to find a period when rates were as low as they are today, you would have to expand your chart back to the early 1960s. In the world of finance and free markets, that is ancient history and is proof that today’s rates are indeed historically low. Does this mean that they will not go any lower? Absolutely not. If we follow the trends of the chart and believe in averages, it sure looks like rates will be rising over the long term. But, if we have common sense, we use a favored line of the mutual fund industry: “Past performance is not an indication of future returns.” No kidding.
Of course there are other things to consider when deciding if you should refinance your commercial real estate. Many of them, particularly the specifics of your individual situation, should be discussed directly with your lender or mortgage broker. For instance, only hard data and a calculator will help you determine if the costs associated with refinancing can be recaptured during your anticipated hold period of the asset. You will most likely pay an upfront fee to your lender and, if you use one, to your mortgage broker. You will also pay for an appraisal and other due diligence costs, along with legal fees and other professional services. You should weigh these costs against your anticipated savings from lower monthly debt payments, to determine if a refinance makes financial sense.
If it were that straightforward, however, it would be easy. Some costs, no matter how much an economist tries to quantify them, just can’t be punched into a financial calculator. To some, that means the opportunity cost and headaches of spending numerous hours working through the refinance transaction. To others, it means the ability and sacrifices needed in order to work with banks and bankers whom you hopefully like and trust. To me, however, it means the ability to sleep at night.
Tossing and Turning
There are few things that I appreciate more in life than a good night’s sleep. For those of us in the world of finance today, those nights do not come easy. But it doesn’t have to be that way. For people who have their financial ducks in order and are not completely at the mercy of the markets, sleepless nights are not a foregone conclusion. Easier said than done, right? Well, yes, of course. It is true that everyone, to a degree, is at the mercy of the markets. You would have to live a self-sustaining existence in the woods of Montana (which doesn’t seem like a terrible idea these days) not to be affected to some degree by the markets. If nothing else, that is a painful lesson the world has learned over the past 12 months.
But, that does not mean that you do not have any control. Indeed, you can lessen your exposure to the markets and sleep better at night. By way of example, let’s say that there are two large real-estate owners. Owner A and Owner B each has five properties acquired over the past decade. Owner A uses long-term financing to buy her properties, and she refinances her properties a few months before the mortgages are due several years later. She makes a strong effort to stagger her loan maturities, so that they come due at different times. This sometimes requires locking into mortgage terms that are not necessarily the cheapest in the market, but it’s a price that she’s willing to pay.
Owner B operates differently. He finances his acquisitions using shorter-term debt in order to stay flexible. The flexibility gives him the option to take advantage of lower rates and cheaper fees when they present themselves. When long-term rates drop down to seemingly historic lows, he locks several of his properties into long-term mortgages at whatever term gives him the lowest debt payments. As discussed previously, sometimes rates go lower than what seemed like historic lows. If the numbers make sense at this time, Owner B is willing to incur significant prepayment penalties in order to capture even lower rates and lower future debt payments.
The innocent (or not so innocent) shall remain nameless, but these two strategies characterize the operating history of some of the largest and most influential real-estate companies throughout the country. They are in very different situations right now.
Owner A, and the owners who behave similarly, are sleeping at night. Of course, they are feeling significant pain from the state of the markets, and they are likely struggling to meet debt service payments on many properties. If they have loans coming due this year, they are having significant difficulty finding a lender who will refinance the debt. But borrowers like Owner A do not have their entire portfolio facing maturing debt this year, and they are not relying on historically aggressive terms for the numbers to make sense on a given deal. Essentially, they have done everything that they could in order to weather this current economic storm. There is a good chance that they will get through the turmoil with limited damage.
Owner B, on the other hand, is staring at the ceiling all night. You have read about many Owner Bs in the newspaper lately, and the outcomes have not been good. They have enormous amounts of debt coming due, or past due, and they can’t get financing to pay off the existing loans. They have tried to sell one property in order to help pay off another, but the only bids come from bottom feeders, and even desperate sellers are not going there yet. The outcomes have been nothing short of shocking, in the sense that some of the largest real-estate owners are turning keys over to banks in large numbers. Some large-scale bankruptcies of public real-estate companies are possibly around the corner, and the cycle will unfortunately feed upon itself as more and more assets are dumped on the market.
The message is not intended to scare anyone, although it is rather unsettling. But rather the message is reality, and it is intended to make the point that there are consequences to your financing decisions. If you chase after the lowest rates and most aggressive terms for too long, you could suddenly find yourself without any options at all. It’s called being at the mercy of the markets, and it’s not a good place to be these days. I would argue that it’s not a good place to be on any day.
There is great uncertainty in the markets, and indeed the world, these days.
Compared to last year, 2009 seems like a year in which there are few financing options left. At this point next year, 2009 could be remembered as a great opportunity to have taken advantage of low rates and whatever lending appetites remained. If you have debt that comes due within the next two years, by all means, start working towards getting it refinanced. That is, if you can.
The opinions expressed in this article are those of the author, and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. Mark Levine is an independent consultant with over 12 years of experience in commercial real-estate finance and investment banking. He can be contacted at marklevine05@gmail.com. Copyright © 2009 by Black Point Press. All rights reserved.