Over the next several years it is estimated that over $1.5 Trillion of Commercial Mortgage Backed Securities (CMBS) will be maturing (almost $100 billion by the end of 2013 alone). In many cases, these loans have already been extended by the lenders and special servicers under what is commonly known as an “extend and pretend” paradigm. These loans matured but, even though the monthly debt service was being covered by the cash flow of the properties on a current basis, due to declining property values and tight credit markets, the loans could not be refinanced at maturity without considerable amounts of new equity being invested. With the properties already under water, the owners/borrowers were not willing to put more equity into these projects in many cases. As a result, rather than calling a default and taking back the properties, the lenders and special servicers of these loans agreed to short term extensions and “pretended” that everything was OK. In essence, they put off the day of reckoning. That day is now arriving in a big way as, by some estimates, 50% to 60% of these loans will fail to refinance at par.
What does this mean for tenants? It means that, in many instances, they may command considerable negotiating leverage when their leases come up for renewal. To understand the impact these maturing loans have on a tenant’s negotiating leverage, it is important to understand how lenders underwrite properties.
The value of commercial properties is driven by the income streams they generate and the quality of those income streams. Quality is a combination of the credit of the tenant(s) and the amount of term remaining on the existing leases. For example, a 10 year full building lease with Apple is very financeable because Apple’s credit is strong and there is sufficient term to amortize the loan before the lender needs to worry about lease rollover exposure (i.e., what will happen when the lease expires). However, how will a prospective lender (or buyer) feel about a building where the anchor tenant’s lease is expiring in two years? This creates uncertainty in underwriting and the lenders will need to assess and account for numerous risks: specifically, how much will it cost to retain the tenant, how long will it take to replace the tenant if it leaves, and at what cost?
Because of the uncertainty created by lease expirations, in many cases, lenders ascribe little or no value to leases that will be expiring in the near term. When underwriting the asset they assume that the tenant will leave when their lease expires and that the owner will be faced with a vacancy. That means rent interruption and expensive releasing costs must be factored into their valuation model. With little or no value attributable to these existing leases, it can be extremely difficult for the owner to establish the building valuation necessary to refinance his existing debt or finance a new acquisition. Thus, getting tenants to recommit long term to the building, even if prematurely, is essential to the landlord’s overall capital strategy and perhaps even his ability to retain the asset.
Thus, if a tenant’s lease is expiring within three years of a scheduled loan maturity, it may have significant leverage in negotiating a lease renewal. The bigger the lease relative to the overall building, and the stronger the tenant’s balance sheet, the more leverage the tenant will have in the lease negotiations.
No negotiation should be entered into without understanding the motivations, circumstances and needs of the other party. In the case of landlords, no facts or circumstances may be greater than his current loan and leasing status. Over the next five years, many of the loans that were originated during the height of the historic CMBS boom will be coming due. In many cases, these loans will be in trouble and the tenants will hold the key to the landlord’s and building’s future. That means that tenants, more than ever, need to understand the relative value their leases represent and, therefore, the leverage they have in any lease renewal negotiations. If a landlord approaches you about an early renewal, there may be a reason to step back and make some inquiries. Likewise, if a broker is recommending you execute an early lease renewal, make sure you are securing a fair share of the value you are providing to the landlord.
For more information contact Glenn Blumenfeld