Refinancing Boom Exposing Risks in U.S. Property Bonds

By Sarah Mulholland  

A $40 million penalty wasn’t enough to keep the owner of San Francisco’s Parkmerced apartment complex from the chance to lock in record-low interest rates and take advantage of the property’s $1.5 billion value.
While a landlord willing to pay almost 63 times the average fee to refinance early is a bullish sign for commercial real estate, it’s less so for bond investors facing $295 billion of mortgages that come due during the next three years. That’s because the securities are increasingly tied to the market’s weakest properties, many of them financed during the peak of the real-estate boom in 2007, as the strongest are paid off.
More property owners are jumping on a drop in financing costs and loosening terms to pay off their mortgages. That helped shrink the amount of
debt maturing before the end of 2017 from $332 billion at the start of 2014, according to Bank of America data.
“If you’re a well-capitalized entity, you’re going to do it,” Richard Hill, a debt analyst at Morgan Stanley, said in a telephone interview. That could leave commercial-mortgage bond investors “holding the bag on a bunch of lower-quality loans.”
Properties such as skyscrapers, shopping malls, hotels and apartment complexes are attracting investors from sovereign wealth funds to insurance companies as they seek higher-yielding assets amid six years of Federal Reserve policies to hold short-term interest rates near zero.

Parkmerced Deal

For Parkmerced, San Francisco’s largest apartment complex, owner Maximus Real Estate Partners refinanced its $450 million, 3.83 percent mortgage to lock in a 2.87 percent rate, data compiled by Bloomberg show.
It also got an additional $773 million in loans to buy out its partner on the property, Fortress Investment Group LLC (FIG), according to documents for investors in a bond offering linked to the complex. The 9,000-resident property near Lake Merced was valued at $1.5 billion in September, the documents show.
Such early payments may help accelerate a new wave of bond offerings tied to the debt. Wall Street banks are on pace to issue $100 billion of securities backed by commercial real estate this year after issuance doubled to $80 billion in 2013, according to data compiled by Bloomberg. Sales, which peaked at $232 billion in 2007, are poised to climb to $140 billion in 2015, Credit Suisse Group AG analysts led by Roger Lehman forecast in a Nov. 21 report.

Retention Rules

Sales of the securities also are being fueled by rules that will require banks to retain some portion of loans that are sold to investors as securities, according to Morgan Stanley’s Hill. That may increase financing costs when they take effect in 2016.
Ray Potter, founder of R3 Funding, a New York-based firm that arranges financing for landlords and investors, said he’s advising clients not to wait to refinance as economists forecast the Fed will raise rates next year for the first time since 2006. There has been a surge in borrowers looking to refinance in the past couple of months, Potter said.
“If you like that coupon, lock it in for 10 years,” he said. While the interest rate could dip even lower, it’s not worth the risk because “when it moves higher it moves fast,” he said.
In aggregate, U.S. commercial real estate values have surpassed the November 2007 peak by 0.2 percent, as measured by Moody’s/RCA Commercial Property Price Index. Prices in major markets, which include cities like New York and San Francisco, have exceeded the peak by about 13 percent, Moody’s said in a report this month. Values in smaller markets are stuck at levels that are 10 percent below the peak.

Boosted Optimism

Borrowers that aren’t taking advantage of cheap financing could have a problem such as a vacancy or a decline in revenues preventing them from doing so, according to Alan Todd, an analyst at Bank of America.
The buoyant real estate market is boosting optimism defaults on loans in commercial-mortgage securities won’t be as bad as first anticipated after the financial crisis.
“As we get closer, the expectation is there should be increasingly less hype about the wall” of debt coming due, said Bank of America’s Todd. “What looked like a mountain in 2010 will eventually look like a foothill.”
Investors may be over-estimating the recovery, said Morgan Stanley’s Hill. Even as prices for top-tier real estate in prime locations surge to new records, values for many buildings in smaller cities and towns are languishing.
“The assumption that property values are now above their 2007 peak is not necessarily a fair assumption,” he said. “This begs the question: Are expectations too high now?”
While debt backed by good properties in large cities shouldn’t be difficult to refinance, borrowers in large swaths of the country where values have been largely flat will come up short, R3’s Potter said.
“Somebody will have to take the pain,” he said. “Something’s got to give.”