Special Report, Flexible Finance: US CRE loan structures bend under borrower pressure

A major US non-bank lender makes a loan against an empty Manhattan office building, with plans for a $50m renovation. “The presumption, based on the quality of the sponsor, is that they will sign leases and move towards the ability to refinance,” an executive with the lender says.

“But what if no leases are signed? What if they ask too much in rent, or the market has been destroyed? What if the cash flow isn’t what we’d anticipated? What if I underwrote at $52 a foot and the borrower wants $60?”

Some of these questions are up in the air, given the unpredictable nature of commercial real estate cycles. But they lie behind the options and covenants relating to a loan’s lifecycle that are worked out when it is structured, to avoid big headaches later on.

The challenge is that lender/borrower relationships tend to ebb and flow, depending on the state of the commercial real estate cycle. Now, as most lenders would agree, a healthier market with more liquidity is giving borrowers leverage (no pun intended) to make greater demands.


“As the number of capital providers continues to increase, borrowers seek more concessions and often get them from less disciplined lenders,” says Christian Dalzell, Starwood Property Trust’s chief of originations. “Pricing continues to compress and yield-focused lenders are losing discipline over structural features. Other lenders are forced to sacrifice pricing to maintain structure. The key to success is finding the right balance and being willing to walk away  rather than stretch to justify deals.

“Lenders will have to do more business to earn the same amount,” he says. “That tests your conviction on bigger deals, and many will be tempted to be more aggressive. We are very focused on maintaining our discipline and our portfolio’s credit quality. In the current environment, borrowers and brokers are aggressively pursuing very tight pricing and aggressive structural features.”

Tough negotiations on terms

Lenders inevitably give up margin as the cycle progresses. In the past 12-18 months US pricing has fallen up to 150 basis points, lenders interviewed for this article said. But as Gary Otten, MetLife’s head of real estate debt strategies puts it, there are a range of additional “bells and whistles” on a deal that are negotiated very hard before closing.

Setting projected rents is just one thing a lender works out when underwriting a loan, particularly on transitional assets. A range of other negotiations take place over structure; for instance, call protection, minimum debt yields and net operating income requirements, cash flow sweeps and loan duration.

A debt yield ratio (net operating income divided by a loan amount, times 100) of 10% means a lender would enjoy a 10% cash-on-cash return if it foreclosed on the property on day one. Naturally, borrowers want this to be lower and lenders higher.


“Many deals have cash flow sweeps or traps that are activated if the debt yield falls below a certain level,” says Mike Nash, head of Blackstone Real Estate Debt Strategies. “Borrowers and lenders always negotiate the structure around these tests and some deals can be won or lost on this basis.

“There are two parts to a cash flow sweep: when it’s activated and what happens to the money once it’s swept. Usually the cash stays in the system and can be used for operating and capital expenses; at times it is released to the borrower if property cash flow has risen through the trigger level.”

Yield maintenance, meanwhile, sets prepayment premiums allowing borrowers to cut loan durations.

Otten says: “Lenders that don’t want to negotiate loan terms that would otherwise increase credit risk start easing up on things like prepayment protection instead, which makes it less expensive for a borrower to get out, say, in year seven of a 10-year loan.”

Nash adds: “When we price and structure loans we think about many variables. But in the end it’s a judgment call. We look at the sponsor’s reputation, the validity of their business plan, real estate quality, the amount of leverage, the pricing and structure.”

Joint bids allow some lenders to compete on pricing to win a deal. Otten says a single lender might go up to a 75% loan-to-value ratio at a cost of 250bps, but another pair might provide a first mortgage up to a 60% LTV ratio, at very low pricing given the low risk, then combine with a mezzanine lender providing the 60-75% element, at a blended price, beating the 250bps single-lender bid.

But Otten and other lenders say they rely on relationships for a large chunk of business, and that those relationships aren’t worth jeopardizing over, say, 50bps of margin.


“Our business model is driven by our ability to structure to meet our borrower partners’ needs and focusing on assets where our scale and ability to understand and underwrite complexity reduces the level of competition,” says Jeffrey DiModica, president of Starwood Property Trust.

“Every asset and loan is different. If you go into a negotiation with a pre-set list of boxes to check, you will do very few deals, or be left with the ones you shouldn’t do.

“It’s a much different market for lenders who rely on highly competitive or brokered deals. Mid-sized brokered deals could have 10-20 bidders, and one is bound to miss a structural nuance, or give in on an important term to get the loan, creating a race to the bottom. We wont chase those deals.”

Brokerage now accounts for a greater percentage of deals, some lenders say, implying that borrowers have additional options and pull. Market participants also report more lenders writing interest-only loans to gain business. But lenders and borrowers say there is much more discipline in the current cycle and are “cautiously optimistic” that this will hold.

At the top of the last cycle, leverage hit 90% and some borrowers gradually cut equity in deals as much as possible. Today, sponsors still put significant equity into core and transitional deals, usually around 30%.

Discipline in the market

“At the end of the last cycle, [sponsors] put 90% leverage in to get extra yield and just 10% equity,” said Mesa West Capital principal Raphael Fishbach at last month’s Real Estate Capital roundtable. “If we see  80% or 90% leverage requests again, my warning bells will go off. But I’m cautiously optimistic that discipline will continue.”


Otten adds: “Lenders were giving out additional proceeds and not really charging for it… that’s the slippage you don’t want to see. We still see discipline on both sides. Borrowers do not want to lever up as much as in the last cycle and you don’t really have a lot of lenders ready and willing to do that.”

While most lenders see ample discipline in the current cycle, they warn that CMBS conduit lenders are the most likely to push on proceeds and interest-only loans.

“What could change all this is the return of pro forma CMBS underwriting,” says Jeff Friedman, co-founder and principal at Mesa West Capital. “CMBS originators are less focused on structure, as they sell loans they originate three months later. So they tend to include only minimally necessary covenant protections. As a result, if CMBS starts to provide floating-rate loans on transitional properties again, structure could deteriorate in the overall bridge loan market.”

He adds: “CMBS has had the opportunity to come back [on the floating-rate side] but it hasn’t happened yet.”

Additional pressure could come from an influx of real estate private equity funds  lacking the experience of seasoned debt lenders and more willing to make concessions on deal structure.

Lenders give less ground on transitional assets


Transitional assets naturally carry more risk than stabilised assets. Loans on these assets entail an asset-based approach to underwriting, as opposed to a cash flow-based approach. Transitional lenders evaluate the potential of the asset or project to increase cash flow.

“It’s a ground-up underwriting of in-place cash flow, but also prospective cash flow,” says Jeff Friedman, co-founder of Mesa West, which is known for its transitional lending operation.

Once that assessment is made, lenders placing loans on transitional deals are less willing to give ground on structure than a lender placing a loan on a stabilised asset would.

Starwood Property Trust’s  Christian Dalzell adds: “Transitional lenders are less willing to give up on structure than a lender on a stabilised asset. It’s more of a ‘take it or leave it’ situation for the transitional borrower.”