August saw a major jump in corporate borrowers refinancing their properties, an indication of the US commercial real estate (CRE) market’s health as well as elevated concerns that interest rates may soon rise.
Trepp, a New York-based provider of commercial real estate-related technology and analytics, recorded the defeasance level in August at $3 billion, compared to an average of $1.2 billion over each of the previous 12 months. Defeasance allows borrowers to refinance CRE loans after replacing lenders’ cash flows from the original loan with that of risk-free assets such as Treasuries. It benefits borrowers when the legal and other costs associated with defeasance are outweighed by the loan costs likely to accrue later, should rates increase.
“The added costs associated with these pre-pays and defeasance are offset by the increased debt available due to net operating income (NOI) growth, value appreciation and the often lower interest-rate than that of the original loan,” noted Fitch Ratings in an August report.
Defeasance levels have been elevated for the last year and a half, since it became clear the Federal Reserve’s Quantitative Easing (QE) bond-buying program was on schedule to be phased out. Joe McBride, a research analyst at Trepp, said a similarly high defeasance level in September would more definitively point to a trend, and if that turns out to be the case it suggests borrowers’ concerns about rates rising soon has jumped as well. He added that a likely factor appears to be the imminent elimination of QE.
“The Fed has said it will keep rates low, but it remains to be seen what the availability of credit will be,” Mr. McBride said. “If there’s less liquidity in the market, then rates will naturally move upward.”
In addition, loans can’t be refinanced if they’re under water—that is, they exceed the value of the property—and many CRE loans were in the wake of the financial crisis, with property values returning slowly except in major metropolitan areas.
“Another positive aspect to this is property values and the incomes these borrowers are generating are high enough to warrant defeasance. This is a good sign for property values and the fundamental health of the properties behind the loans,” McBride said.
He added that another factor may be the competitive lending environment and lenders’ current willingness to provide more leveraged loans or lend to borrowers who may not have received loans a few years ago.
Chris Bushart, a senior director at Fitch Ratings, said the agency is seeing defeasance across all the major property types, and that it’s continuing to observe “take outs” of loans originated in 2010 and later. Some are floating-rate loans with maturities of five or so years, after extensions, and others are longer-term fixed-rate loans with maturities typically of 10 years.
“It’s interesting that some borrowers are looking to refinance so early,” Mr. Bushart said, adding, “But that way they know they will have this low rate locked in for 10 years and they can optimize their balance sheets. It’s really taking advantage of the opportunity presented to them right now.”
Fitch notes in its report that prepayment penalties ranged from 1 percent to 25 percent and averaged approximately 10 percent, as a percentage of the balance prior to disposition. And, in addition to the number of prepayments increasing, the size of individual loans being prepaid in 2014 has also increased compared to the prior three years.