Commercial real estate loans are taken out to purchase, construct and maintain income-producing properties. These loans typically have terms of three to ten years, but the monthly payments are usually not scheduled to fully repay the loan in that period. At the end of the term, the entire remaining balance of the loan (a “balloon payment”) becomes due, and the borrowers/owners are required to refinance and take out a new loan to pay the balloon.

During the next seven years, 1.9 trillion dollars in commercial loans will mature. Experts predict that over one trillion dollars of such loans will face significant refinancing problems. In addition, nearly half of the commercial real estate loans that will mature during the next five years are presently “under water”, meaning that the borrower owes more than the property is worth. Problems have already begun to appear. Since 2006, the default rate on commercial real estate loans has skyrocketed from about 1% to roughly 9%.

The refinancing problem facing commercial property owners is two-fold. First of all, there is very little available credit, which declined dramatically after 2007 in the wake of the residential mortgage and credit crisis. This is true even for those loans that would otherwise qualify for refinancing under the new, tighter underwriting standards being imposed. Many commercial real estate credit markets have either shut down completely or are operating at dramatically-reduced levels.

The second and even more serious source of refinancing problems has to do with the fact that a large number of the commercial mortgages that originated during the bubble years will simply not qualify for the financing under the new underwriting standards. To qualify for refinancing under current standards, a borrower must generally satisfy at least two criteria: (i) the loan to value ratio (“LTVR”) must be no greater than 60-65, and (ii) the debt service coverage ratio (“DSCR”) (assuming a 10-year, fixed rate loan with a 25-year amortization schedule and an 8 percent interest rate), must be no less than 1.3. Even if the property is producing sufficient income to satisfy the DSCR (which is often not the case given rising vacancy rates and declining rents), most loans made during the bubble years were made at a LTVR in excess of 80%, which means that, given the almost 40% reduction in commercial property values since 2007, an extremely large infusion of borrower equity would be required to refinance the loan. Because many borrowers will either be unable or unwilling to put the necessary additional equity into the properties requiring financing, borrowers will be faced with difficult choices.

While there is no easy solution, there are some steps commercial property owners can take to increase their chances of being able to obtain refinancing or determine a viable alternative, including the following:

• Assume that it may take up to one year to refinance a commercial loan and develop a strategy as early as possible. Depending on the situation, take steps to raise the additional equity that may be necessary to comply with the new underwriting standards, position the property for sale if additional equity cannot be raised and the property cannot be refinanced, or take steps to improve the property’s performance to increase cash flow to support a higher property value to satisfy the more stringent LTVR requirements.
• Approach your lender and seek an extension of your existing loan. Again, the earlier this can be done, the more likely you are to be successful and to avoid having the lender impose onerous conditions on a last-minute extension request. Under the right circumstances, many lenders are willing to consider loan extensions for a fee, an increase in interest rate, or other borrower concessions. However, there are only certain situations where extensions make sense.
• If you cannot pay your debt service, you have little to gain from a term extension. Additional time will not enable you to pay your debt service if you cannot do so already. There are a few exceptions, such as a case in which you expect a major increase in revenue due, for example, to a large new tenant whose lease begins in a few months. In such a case, you may be able to be sustained by the extension long enough for the new tenant to begin paying rent that will allow you to continue paying your debt service. The most promising use for term extensions is if you have sufficient property income but cannot refinance due to market-caused events, such as a decline in the value of your property, but you and the lender both believe that the property value will recover enough over the term of the extension to put you back into positive equity.
• If a term extension alone will not work under the circumstances, approach your lender and seek some other form of “workout”. Workout strategies, such as lowering the interest rate or reducing the principal balance of the loan, or both, may help lenders avoid the significant costs and discounted sales prices associated with foreclosures.
• For example, borrowers whose loans are underwater have an incentive to default in order to avoid an almost-certain loss. Workouts that do not address that incentive run the risk of simply delaying the inevitable. In such cases, principal reductions remove the incentive for these borrowers to re-default, since the new principal balance will usually be less than the projected sale proceeds from the property. The borrower will no longer have to come up with cash to pay off the loan when they sell the property. On the other hand, principal reductions are not favored by many lenders because they are costly and often force the recognition of a loss on what may already be a weak balance sheet. An interest rate reduction, on the other hand, reduces the monthly payment and may prevent a marginal borrower from defaulting, while not requiring a lender to book a large loss. However, rate reductions do not remove the incentive for underwater borrowers to default.
• When obtaining a new construction loan, attempt to negotiate as many loan extension or “mini-perm” options as possible since you can no longer assume that take-out financing will be available at the end of construction. A mini-perm loan is a short-term loan that is offered at the maturity of a construction loan to enable the borrower to establish an operating history in preparation for obtaining a permanent term loan.
• Approach multiple lenders and qualified loan brokers, and do not simply rely on the lending sources you have used in the past. Contact new lenders and sit down with them on a face-to-face basis to discuss lending needs. If you have a long relationship and significant deposits with a business lender, you may want to approach them and tell them about your situation. Many banks do not want to lose a significant deposit relationship and will work with you to provide a loan, if possible.
• Explore mezzanine debt sources as an option to help with the extra equity that may be necessary to obtain refinancing. Mezzanine financing, which is generally subordinate to debt provided by senior lenders, is debt capital that gives the lender a right to obtain an ownership interest in the borrowing entity if the loan is not paid back on time. However, since mezzanine financing is usually provided very quickly with little due diligence on the part of the lender and little collateral on the part of the borrower, this type of financing is expensive, but it may be the only option to avoid foreclosure.
• In some circumstances, the only alternative may be to let the property go. Properties with very poor operating fundamentals, such as high vacancy rates, may be unlikely to recover under any probable scenario. In these cases it may be best to resolve the situation promptly by allowing the lender to take back the property. In order to avoid foreclosure costs and delays, many lenders are willing to agree to an alternative to a traditional hostile foreclosure, such as a deed in lieu of foreclosure.