Pre-Stabilized Financing - Important Considerations for CRE Owners

November 2024

CRE Market Conditions Delay the Move to Perm Financing

Over the last twelve months, commercial real estate owners have watched as stabilization periods have expanded, largely due to market conditions. Across asset classes, including multifamily, storage, and industrial, rent growth has slowed and vacancy levels have increased modestly from the previous market cycle. Within the storage asset class, existing customer rent increases (“ECRIs”) have remained effective in generating rent growth from in-place tenants, but growth in asking rents for vacant units has remained muted this year.

Additionally, construction and operational costs have remained elevated after the bout of inflation experienced over the last twenty-four months. In some cases, higher costs and labor constraints continue to extend construction timelines, thereby delaying the lease up phase. The delay in achieving stabilization impacts business plans and projections, and importantly, it makes it more difficult for owners to transition to perm financing.

Lengthier Stabilization Periods Impact Financing Options

Under a variety of market conditions, owners tend to move to perm loans as quickly as possible to capture key benefits. Most importantly, this strategy can reduce the debt service burden (interest rates on perm loans tend to be lower than construction or bridge debt) and eliminate recourse obligations for the borrower. However, because of the extended stabilization periods and interest rate uncertainty prevailing in today's market, many owners are opting to hold on to more costly construction or bridge loans rather than lock in a perm product. There are concerns about taking on perm financing during a slower lease up period, and there is speculation that perm loan borrowing costs will decline in the coming months as monetary policy becomes more accommodative.

However, in today’s market, obtaining pre-stabilized perm loan financing is a potential strategy to help offset elongated stabilization time frames. It allows the borrower to lock in a rate that provides satisfactory cash flow to investors while also mitigating the risk of higher borrower costs in the future. Most pre-stabilized perm loans also allow the property to achieve full economic stabilization without the borrower having recourse or covenants common with their existing bridge or construction loans.

Considering Pre-Stabilized Perm Financing Across the Full Range of Interest Rate Paths

One of the primary arguments against moving to perm financing prior to the full stabilization of the asset revolves around the possibility that all-in borrowing costs will decrease in the coming months as the Fed continues to maintain a more accommodative stance. However, since the Fed began cutting short-term rates in September, the 10-year Treasury rate has increased by about sixty basis points at the time of this writing. The lesson for owners is that the long-term rates underlying perm loan pricing can move in contrast to the short-term rates that are controlled by the Fed.

Viewed through this lens, owners should consider the full range of potential rate paths and the impact on financing costs. While many owners are holding off on obtaining perm loans, it is important to weigh the possibility that current all-in perm financing costs could increase as we move into 2025. Owners who are currently considering perm financing should center their analysis around whether the loan package will be accretive to the investment over the full holding period, and they should avoid fixating on the possibility of missing a decrease in long-term borrowing costs in the coming months. As successful long-term owners know, it is generally most advantageous to obtain financing on acceptable terms, to focus intensely on managing the physical asset, and to execute on the business plan.

Life Companies May Shape the Perm Loan Market Over the Coming Months

While challenges remain, many lenders recognize the need to adapt to the current environment and are stepping up to support owners navigating pre-stabilized financing. Earlier this year, the CMBS market saw increased activity, financing was extended at relatively aggressive debt yields in the 8.5% range. It became apparent that owners were taking advantage of lenders’ willingness to issue credit on advantageous terms, and long-term CMBS products quickly became a viable pre-stabilized perm financing solution. More recently, debt yields on CMBS have effectively increased 100+ basis points (loan sizing is now constrained by DSCR metrics as interest rates have increased) such that the product no longer works for pre-stabilized perm financing.

While CMBS is currently not an option for pre-stabilized assets in most cases, life companies appear to be in the preliminary stages of picking up some of the slack. The Talonvest team recently met with a life company extending pre-stabilized perm financing at a 200bps spread over Treasuries for a property with an 8.5% in-place debt yield. It is unclear whether life companies will continue to allocate capital to the pre-stabilized borrower segment given the propensity for life companies to focus on debt yields closer to 10%+ for most financings, but it is certainly a development that owners of pre-stabilized assets should monitor.

Final Thoughts

Securing pre-stabilized financing is a complex but crucial step for CRE owners aiming to keep business plans on track. In light of slower stabilization and delayed access to permanent financing, owners need to be proactive in exploring all options. They should consider each option in the context of interest rate uncertainty and understand that significant benefits may be realized from locking in a perm loan provided the right terms are available. Some lenders are extending terms that should allow owners to obtain perm financing over the next several months and enhance the long-term value of the investment.