Sometimes, like our gumball example, things are not well thought out. Sometimes bankers place themselves in a position that will result in a higher probability of problems. An example of this is when it comes to analyzing tenant leases for commercial real estate.
While we will tackle the determination of the quality of leases in another episode, getting your maturity date right in relationship to the lease structure of a property is a key factor in the probability of default. Instead of picking your maturity date at random or at the request of the borrower, we have a better way.
Many banks set their loan maturity first without every knowing the maturity of the leases. If you look at all the things that could go wrong with a commercial loan where there is a balloon payment at the end, a coterminous lease and loan maturity (or when these are within 90 days of each other) accounts for approximately 15% of all loan problems. That is, a loan that needs to refinance right when the building’s leases are turning over or going vacant could be a loan bound for problems. If you look at a loan probability of default by year, after peaking in year 2 of a loan, the risk quickly tails down after year four only to spike again during the last year because of the refinance risk. Thus, if you want to focus on one thing to help lower your risk, looking at lease expiration is worthy of your time.
When demand for rental space outstrips supply during the lease expiration, all is well. However, when supply outstrips demand, the probability of a maturity default jumps to astronomical levels placing he lender at risk. Without a solid set of leases in place that can adequately service the debt, refinancing by the current lender or a new lender will grow more difficult for both the current lender and the borrower. Uncertainty over the future of the leases will, at a minimum, cause debt service expense to increase.
The better approach is for loan officers to look at the lease structure FIRST and then set the loan maturity. If the average age of the leases is 10 years, then a balloon loan’s maturity should not go past year 9. This gives the lender plenty of time to negotiate with the borrower should there be a future cash flow problem. This is simple with a single tenant lease. In cases where there are multiple leases, an understanding should be had on how these leases roll over and what a common term might be. In cases where the lease structure is shorter, say 3 years, then making a 5 year loan is better than making a 6 loan as you would not want the second extension of leases to terminate right at the loan maturity.
Of course looking at options within the lease is also key as this will have a factor. Here, bankers should require notification (and flag in their loan management calendar) of when options expires and the outcome of the option. Depending on the future of the market at the time, in cases where the market is deteriorating, the lender may want to place pressure on the owner to make sure the options get exercised even if it means renegotiating part of the lease. This tactic alone will help mitigate some of the refinancing risk.
As a rule of thumb, you want a minimum of 120 days (we recommend a full year if possible) of distance between the balloon loan maturity and the expiration of the minimal amount of leases that can safely service the debt. By doing this one simple structuring trick, loan maturity defaults will dramatically drop during times of credit stress.
Without forethought of the lease structure, bankers that have balloon payments coming due will have to ascertain the forward market of rental and cap rates which is always a difficult to do. This injects an extra layer of analytical complexity that increases risk. By structuring the loan maturity to give bankers ample time to work out problems, forward lease analysis can be avoided and a solid loan can be negotiated from the start. Without taking the lease structuring into account, bankers might as well be popping bouncing balls in their mouths instead of gumballs.
Submitted by Chris Nichols on June 10, 2013