Determining whether conventional financing is right for today’s interest-rate environment
These days, there’s a smorgasbord of financing options available to commercial real estate and hotel owners, developers, and sponsors. These include bridge and permanent debt via securitized loans and CMBS conduits, bank loans, credit unions and life insurance financing, SBA loans, and much more. Selecting the right financing largely depends on the type and risk profile of the asset being financed. The proliferation of options can be overwhelming and the nuances easily misunderstood. This confusion often leads to financing types being incorrectly categorized or defined. One example is the concept of conventional financing. Let’s take a closer look.
WHAT IS CONVENTIONAL FINANCING?
There’s a misnomer among borrowers that conventional financing is the best type of financing, but most don’t know what conventional financing is. They’ve heard horror stories about CMBS financing’s tough servicing standards and inflexible servicers. Consequently, they automatically assume they should choose the opposite of CMBS financing – or what they perceive is conventional financing.
Why else do borrowers think they want non-CMBS – or what they call “conventional” – financing? Two words: interest rates. There’s overarching, wishful thinking among owners that current high interest rates are not sustainable, and there will be an opportunity to refinance sooner at lower levels. Knowing that many balance sheet lenders, such as banks, credit unions, and life insurance companies don’t impose the same defeasance or yield management prepayment penalties that a CMBS loan includes, borrowers conclude that anything outside CMBS is considered conventional financing and what they need.
Conventional financing, however, isn’t a stand-alone product. Essentially, any loan type not administered by the Small Business Administration (SBA) or through another government program is considered conventional financing. Loans from a bank, credit union, or life insurance company, as well as CMBS loans, are all conventional financing. In fact, even within the SBA 504 product, the bank portion of the loan is considered conventional financing.
Misclassifying financing types can have serious consequences, because borrowers may overlook viable, strategic options that are a better fit for their asset and business plan. Borrowers assume they should limit their scope to what they think is conventional financing– typically a bank, credit union, or life-insurance loan. This issue doesn’t occur quite as often with more sophisticated borrowers with financing and accounting infrastructure who understand the benefits of non-recourse CMBS financing.
To get a better picture, it’s important to look more closely at the prepayment penalties and other trade-offs for four of the more-common types of financing.
1. LIFE INSURANCE FINANCING
Life insurance companies typically offer a pre-defined, step-down pre-payment structure. For example, for a five-year life insurance company loan on a hotel, the pre-payment penalty could be 5% in year one, 4% in year two, and so forth. Unfortunately, most life insurance companies don’t provide cash out above the current loan for their borrowers. Furthermore, leverage is limited to 55% loan-to-value for hotels, 65% for multifamily, and 60% for other commercial real estate. These lower leverage life insurance company loans can be called conventional loans.
2. CREDIT UNIONS
Credit unions can be a strategic capital source because they frequently have little or no pre-payment penalties. However, this is because most credit unions only offer full recourse loans. Leverage is another trade off with this type of conventional financing, as credit unions tend to top out at 55% to 60% loan-to-value for hotels.
3. CREDIT UNION SYNDICATION ORGANIZATION (CUSO)
Essentially, CUSOs are brokers trying to syndicate a loan with different credit unions. Although CUSOs can offer attractive terms, they also come with one- to two-point upfront fees and additional risk of execution. After taking the application, the CUSO still must go out to their member credit unions to get them to participate. If the CUSO fails to find willing participants, the borrower will lose both time and money. Many borrowers are willing to pay the points as tax for this type of conventional financing if it means more flexible pre-payment terms.
4. BANK LOANS
In an environment where interest rates are elevated and bank lenders are turning more conservative, some capital providers such as CUSOs or a bank syndication lender become more attractive. Conventional loans provided by banks often come with the burden of a fixed-rate swap. An interest-rate swap is a hedging instrument that banks use to fix the interest rate to the borrower on a floating-rate loan. The swap instrument can be a win-win for the lender and the borrower. The lender gets to originate a floating-rate loan on its balance sheet, which allows it to have a constant spread over an index, and the borrower enjoys the protection of a fixed-rate loan. The good news is the bank and borrower are insulated from interest rate risk. The bad news is the swap instrument comes with a potential borrower pre-payment penalty. This penalty could be in the form of yield management or a swap breakage fee. It’s not surprising that smaller regional banks are pushing for loans with interest rate swaps to minimize risk.
HOW TO NAVIGATE TODAY’S MARKET
The current rate environment is creating challenges for all financing providers. Today’s borrowers are ultra-sensitive about committing to longer term loans with high pre-payment penalties. This is turning out to be a hard exercise for borrowers and mortgage bankers who are looking for loans that are conventional in nature with lower pre-payment burdens. Higher interest rates are pushing the entire capital markets to adjust and adapt to fit the needs of commercial real estate and hotel owners. This is the time to call on a seasoned intermediary that has established networks and track record to secure the best financing for your asset, wallet, and business plan.