5 Steps to Assess Refinancing Risk in CRE
Refinancing risk in commercial real estate (CRE) arises when borrowers face difficulties refinancing maturing loans due to unfavorable terms, rising interest rates, or declining property values. With over $1.3 trillion in CRE loans maturing between 2023 and 2024, this risk is pressing, especially for office properties and loans issued at historically low rates. Here's a 5-step process to evaluate and manage refinancing risk effectively:
Review Loan Maturity Timelines: Identify loans nearing maturity, especially those with short terms, large principals, or interest-only payments.
Analyze Borrower Financial Health: Assess debt service coverage ratios (DSCR), cash flow, credit history, and collateral adequacy.
Monitor Market Trends: Track interest rates, property values, and sector-specific dynamics to anticipate refinancing challenges.
Examine Loan Terms: Evaluate loan structures, covenants, and underwriting standards to spot potential obstacles.
Develop Risk Mitigation Strategies: Create tailored refinance plans, consider loan modifications, and leverage risk management tools.
Key Insight: Rising rates and declining property values make proactive risk assessment critical. Tools like stress testing and platforms like CoreCast can streamline analysis and support informed decisions. By following these steps, you can safeguard your portfolio and navigate refinancing challenges with confidence.
Refinance Analysis Tool in Excel
Step 1: Review Loan Maturity Timeline
The first step in evaluating refinancing risk is to map out exactly when your loans are set to mature and identify those that could pose a threat to your portfolio. This timeline analysis helps you spot potential risks before they escalate into serious problems.
In 2024 alone, nearly $820 billion in U.S. commercial-property loans could reach maturity. Of that, about $600 billion is highlighted by MSCI Mortgage Debt Intelligence data. To add to the pressure, $214 billion in loans that matured in 2023 were neither refinanced nor had their collateral sold. This creates what experts call a "maturity wall" - a scenario where a large number of loans come due in a struggling market. When this happens during tough economic times, it can squeeze available capital, hurt earnings, and complicate broader strategies.
Find High-Risk Loans
Start by pinpointing loans with the highest refinancing risk based on their structure and maturity dates. Pay close attention to loans with short-term maturities, large principal amounts, or interest-only terms. Interest-only loans are particularly risky because borrowers must refinance the entire principal or make significant balloon payments when the loan matures. If the market takes a downturn, their options could be severely limited.
Loans issued in 2021 represent the largest single group of loans maturing in 2024. Many of these borrowers locked in historically low rates, but now they face considerably higher refinancing costs. It's critical to keep an eye on loans with substantial outstanding balances, especially those exceeding your institution's concentration limits, as these could pose significant risks if refinancing efforts fail.
Once you've identified high-risk loans based on timing and structure, group them by key characteristics to uncover broader patterns of exposure.
Group Loan Portfolios
Grouping loans takes your risk analysis a step further, offering a clearer, more comprehensive picture of your portfolio. By segmenting loans, you can uncover exposure patterns that may not be immediately obvious when looking at individual loans.
Organize your portfolio by property type, location, and borrower profile to better understand your exposure. Different property sectors face unique challenges. For instance, office properties continue to struggle with the shift to remote work, while industrial properties often show more stability. Breaking your portfolio into property types helps identify which sectors are most vulnerable to refinancing risks.
Geographic concentration is another factor to consider. Loans clustered in regions dealing with economic stress, declining populations, or oversupply issues may lead to widespread refinancing difficulties. It's worth noting that bank lenders account for at least 45% of loans maturing in 2025, 2026, and 2027, highlighting the importance of understanding your institution's role in these upcoming maturities.
Step 2: Check Debt Service Coverage and Borrower Financial Health
Once you've identified high-risk loans based on maturity, the next step is to assess whether borrowers can meet their debt obligations. This isn’t just about their payment history - it’s about digging into their current cash flow, overall financial condition, and how well they align with today’s lending standards. With loan maturities mapped out, it’s time to ensure that cash flows can adequately cover debt payments.
Calculate Debt Service Coverage Ratios (DSCR)
The Debt Service Coverage Ratio (DSCR) is a key metric that shows whether a property generates enough income to handle its debt payments. To calculate it, divide the Net Operating Income (NOI) - which is gross income minus operating expenses - by the Total Debt Service (the annual principal and interest payments). The resulting ratio reveals how many times the property’s income can cover its debt.
“Debt service coverage ratio is a basic indicator of your company’s financial health and one that all entrepreneurs should be familiar with.”
Most commercial real estate lenders look for a DSCR of at least 1.25×, though many prefer ratios of 1.5 or higher. A DSCR over 1.0 means the property generates enough income to cover its debt payments, while a ratio of 1.0 leaves no margin for unexpected costs or financial hiccups.
Review Borrower Financial Stability
Cash flow metrics are just one piece of the puzzle. A borrower’s overall financial health plays a crucial role in understanding refinancing risks. Examine their financial statements, credit history, and the adequacy of any collateral. Pay attention to trends in revenue, profitability, and liquidity. Red flags like falling revenue, high levels of debt, or limited cash reserves can increase refinancing risks, especially for loans nearing maturity.
Properties that maintain or grow in value give borrowers more refinancing options. On the other hand, declining property values can restrict those options or result in less favorable loan terms. Evaluate whether the borrower can secure a new market-rate loan under current underwriting standards and what refinancing terms they might face.
Update Risk Ratings
Keeping borrower risk ratings up-to-date is essential as financial conditions shift. Focus on key indicators like changes in cash flow, profitability, and debt levels. Be alert to warning signs such as declining occupancy rates or delays in financial reporting, which could point to brewing problems.
Updating risk ratings regularly provides a more accurate picture of refinancing risks. When paired with maturity profiles, these updates offer a dynamic view of a borrower’s situation. Borrowers with rising risks may need closer monitoring, additional reporting, or early conversations about refinancing strategies. Meanwhile, borrowers with stable financials might be eligible for better terms or less frequent reviews.
Step 3: Check Market Trends and Property Values
After analyzing borrower financials, the next step is to assess how broader market conditions influence refinancing options. Market trends and property values play a crucial role in shaping refinancing strategies. Understanding these factors allows you to anticipate potential challenges before they escalate.
Track Key Market Indicators
While interest rates are a major factor, they’re only part of the equation. To get a clearer picture, monitor other key indicators like cap rates, supply-demand dynamics, GDP, employment rates, and income levels. These elements give insight into the health of the regional economy and its impact on commercial real estate demand, helping you spot potential refinancing risks.
Recent data suggests the market is showing signs of improvement. For instance, the CBRE Lending Momentum Index, which tracks U.S. commercial loan closings, jumped 21% in Q3 2024 and 37% year-over-year. This upward trend is encouraging, but a deeper dive into specific portfolio impacts is essential.
Loan spreads also provide valuable insights. In Q4 2024, the average spread for closed commercial mortgage loans dropped to 184 basis points, a 49-point decline compared to the previous year. Additionally, CBRE’s Agency Pricing Index showed fixed agency mortgage rates fell to 5.4% in Q4 2024 from 5.8% in the prior quarter, the lowest rate since Q2 2023.
Sector-specific trends are equally important. For example, government agency lending for multifamily properties surged by 87% to $53 billion in Q4 2024. While this indicates strong capital availability for multifamily assets, not all sectors enjoy the same favorable conditions. Understanding these nuances is key to refining your refinancing strategy.
These market trends provide a foundation for evaluating property values and stress testing, which are critical for identifying refinancing risks.
Check Property Values
Property values directly impact refinancing by influencing loan-to-value ratios and available equity. Declines in property values can reduce equity, making refinancing more difficult. Borrowers with properties that have lost value may struggle to meet lender requirements or find themselves underwater on their loans.
Recent data highlights the challenges in this area. According to the RCA CPPI index, overall commercial real estate prices fell 6.3% during the three months ending in January 2023. Multifamily properties were hit even harder, with values dropping 7.6% during the same period. These declines are especially problematic for loans with high loan-to-value ratios, as they limit refinancing options.
Adding to the difficulty, rising interest rates have reduced the present value of fixed-income properties. This creates a double burden: higher borrowing costs coupled with lower property valuations make refinancing both harder and more expensive.
To better understand refinancing prospects, examine factors like vacancy rates, absorption rates, and rental trends. Properties in areas with low vacancy rates, steady rental growth, and positive absorption are more likely to secure favorable refinancing terms compared to those in weaker markets.
Run Stress Tests
Stress testing helps evaluate how your portfolio might perform under adverse conditions, enabling you to pinpoint vulnerabilities and strengthen financial strategies. For real estate, this involves testing properties against scenarios like economic downturns, interest rate hikes, market swings, or increased tenant vacancies.
For example, the Federal Reserve’s 2023 stress test modeled a scenario where commercial real estate values dropped by 40%. While this is an extreme case, it underscores the importance of preparing for severe market downturns.
It’s also useful to test more realistic scenarios. Consider scenarios like 200-300 basis point interest rate increases, 15-25% property value declines, liquidity shortages, or 20-30% spikes in vacancy rates. These tests reveal potential weak spots in your portfolio.
A framework offered by the FDIC demonstrates the value of portfolio-level stress testing. In one example, a bank with $124 million in construction and development loans and $22 million in commercial real estate estimated loss rates under moderate and severe stress. Loss rates for commercial real estate were 2.5% under moderate stress and 5.0% under severe stress.
Incorporating stress tests into your financial analysis ensures a proactive approach. Use dynamic financial models that allow you to simulate different scenarios and update assumptions based on current market conditions. This helps you identify risks early and create contingency plans well before refinancing deadlines.
Stress testing also supports better decision-making in areas like capital planning and risk management. By understanding potential losses under various scenarios, you can take steps such as loan modifications, additional collateral requirements, or workout strategies to address refinancing challenges before they arise.
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Step 4: Check Underwriting Standards and Loan Terms
Once you've analyzed borrowers and market conditions, it's time to dig into loan structures. This step is key to identifying potential refinancing challenges. By reviewing loan terms and underwriting practices, you can uncover obstacles before they become costly problems.
Review Loan Terms and Covenants
Understanding the details of your loan structures is critical when assessing refinancing risks. Start by taking a close look at payment schedules, interest rate types, and covenant structures across your portfolio. These factors directly influence a borrower's ability to refinance when their loan matures.
Commercial loans often come with shorter terms compared to their amortization schedules. This creates balloon payments, which can significantly increase refinancing risks.
Another important distinction lies in the type of loan. Recourse loans provide lenders with added protection through the borrower's personal liability. On the other hand, non-recourse loans limit recovery to the collateral but often come with higher interest rates and stricter terms. Even with non-recourse loans, lenders usually include "bad boy" carve-outs, which restore personal liability if the borrower engages in actions like fraud, waste, or voluntary bankruptcy.
Loan covenants also play a major role. The Office of the Comptroller of the Currency (OCC) highlights their importance in their guidance:
“Banks may also require covenants that preserve the borrower’s ability to refinance (e.g., leverage covenants or limits on incremental debt) or trigger action before maturity to protect the bank (e.g., debt service coverage ratios or liquidity ratios).”
Evaluate whether your covenants are designed to ease refinancing or if they unintentionally create hurdles. Well-structured loan terms should act as both a guide and a safeguard, protecting lenders while supporting successful transactions. Think of covenants as your early warning system - they should help you spot issues before they turn into full-blown refinancing crises.
Pay special attention to key underwriting metrics that influence refinancing outcomes. For example, a typical debt service coverage ratio (DSCR) requirement ranges from 1.15x to 1.25x, while loan-to-value (LTV) ratios usually fall between 65% and 80%, depending on factors like property type and market conditions. Loans with metrics on the higher end of these ranges may face more refinancing pressure, particularly in today’s tighter lending environment.
Once you’ve reviewed loan terms, it’s time to adjust underwriting practices to address any risks you’ve identified.
Update Underwriting Practices
Analyzing your portfolio will likely reveal recurring patterns that call for changes to your underwriting approach. Making these updates is essential to staying competitive, managing risks, and improving returns in the evolving commercial real estate landscape.
Manual underwriting processes, while common, come with inherent risks like subjectivity and errors. Considering the sheer size of the market - commercial and multifamily mortgage debt hit $130 billion in 2023 - it's clear that a more advanced approach is necessary.
Set clear criteria for non-amortizing loans and establish firm limits for exceptions and controls. Additionally, consider adopting technology-driven tools to improve consistency and precision in underwriting. AI-based risk assessment tools can analyze a wide range of risk factors, while real-time data provides up-to-date insights on market trends, property performance, and tenant details. These tools help address the inefficiencies of manual processes.
Modernizing your underwriting practices with technology can lead to faster loan processing, reduced costs, higher approval rates, and better portfolio diversification. This is especially critical when dealing with external factors like fluctuating property values.
One area that often requires immediate attention is replacement cost methodology. Rising labor costs and legal changes can significantly impact replacement costs, so it’s essential to update appraisal methods accordingly. For properties with static values over several years, lenders should request justifications, such as updated appraisals, to ensure accuracy.
Finally, implement portfolio risk monitoring to assess and track risks across your entire portfolio. Use data-driven insights to inform underwriting decisions and optimize how you manage your portfolio.
The ultimate goal is to create underwriting standards that strike a balance between effective risk management and market competitiveness. By aligning your practices with current market dynamics, you’ll be better positioned to proactively address refinancing risks and protect your institution's long-term success.
Step 5: Create and Apply Risk Reduction Strategies
Turn your risk assessments into actionable strategies that protect your portfolio and provide support to borrowers.
Build Refinance Plans
Craft refinance plans tailored to the specific needs of your portfolio. These plans are especially important for borrowers identified as high-risk. Banks should proactively develop strategies for borrowers with upcoming refinancing needs. Start by pinpointing loans with weaker debt service coverage, higher loan-to-value ratios, or other indicators of financial strain - these are the cases that demand immediate solutions.
Early communication is key. Reach out to borrowers well before their loan maturity to discuss refinancing options and potential hurdles. Each high-risk loan should have a primary refinancing strategy, supported by alternative plans. For instance, your main approach might involve traditional refinancing under current market conditions, while backup options could include loan modifications, extending loan maturity, or exploring alternative financing sources.
Outline specific action steps, including timelines for documentation, property improvements, and debt service goals. A clear refinance plan not only guides borrowers but also shields your institution from unnecessary risks.
Timing is everything. For example, in February, refinance inquiries jumped by 99% compared to January, peaking in May with requests totaling over half a billion dollars, or 16% of all inquiries. However, by June, inquiries dropped by 50.1% from May levels. This highlights the importance of aligning your refinancing efforts with market trends.
If refinancing proves unworkable, focus on modifying the terms of existing loans.
Consider Loan Changes
When refinancing isn't an option, loan modifications and restructuring can be effective alternatives. These approaches not only help borrowers avoid foreclosure but also allow them to retain ownership.
The Office of the Comptroller of the Currency encourages banks to collaborate with borrowers experiencing financial stress. Modifications might include extending loan maturity, lowering interest rates, or revising repayment schedules. For instance, maturity extensions can give borrowers more time to stabilize their properties or wait for better market conditions. Adjusting interest rates can immediately alleviate cash flow pressures, while revised repayment schedules can align debt payments with seasonal income fluctuations.
In late 2024, many U.S. CRE CLO market participants extended the maturities on floating-rate loans, taking advantage of lower interest rates to give borrowers additional time to stabilize their properties. This strategy also helped offset rising insurance premiums and retrofit costs.
Think beyond traditional modifications and explore creative restructuring options. Adjusting lease terms or restructuring rents can improve cash flow by better aligning with current market realities. A/B structures, which prioritize different classes of debt, and revenue-sharing agreements, which tie repayment to future revenues, can also be effective. These solutions align the interests of both lenders and borrowers during tough times.
When considering modifications, focus on addressing the root of the problem. For example, a borrower dealing with high vacancy rates may need a different strategy than one facing temporary cash flow issues.
Use Risk Management Tools
Leverage technology to strengthen your risk reduction strategies. Modern tools can provide real-time insights into key metrics like debt service coverage, LTV ratios, and market trends, helping you identify refinancing risks early.
Platforms like Fractional Analyst's CoreCast offer robust risk management capabilities tailored to commercial real estate portfolios. These tools provide data-driven insights to support smarter underwriting decisions and better portfolio management. They also help diversify investments across markets and property types, balancing potential losses. For borrowers with variable-rate loans, these systems can identify opportunities to lock in fixed rates, stabilizing cash flow projections. Additionally, hedging strategies such as swaps and caps can guard against sudden interest rate increases.
Combine expert analysis with self-service tools for a balanced approach to risk management. Use the platform for regular monitoring and analysis, while relying on expert input for more complex scenarios.
“Refinancing can be enormously helpful in increasing cashflow, making you better prepared to grow your portfolio and take advantage of commercial real estate’s cyclical nature.”
Use Specialized Tools and Expert Help
Tackling refinancing risk requires more than just spreadsheets - it demands advanced tools and professional expertise to navigate intricate market conditions and make swift, informed decisions. These resources build on earlier steps, offering real-time updates and expert insights to sharpen your risk management strategies.
Direct Service by Expert Analysts
When it comes to addressing complex refinancing challenges, expert analysts play a crucial role. The Fractional Analyst provides experienced financial professionals who specialize in underwriting, asset management, market research, and investor reporting. This hands-on approach is particularly helpful for high-risk loans or properties with unique challenges. Analysts bring a depth of knowledge that automated tools may miss, identifying nuanced risk factors to ensure your refinancing evaluations are both thorough and timely.
This flexible service model works well for one-time projects or ongoing portfolio analysis, adjusting to your specific needs and timelines. If you’re looking for a more self-directed approach, the next section introduces CoreCast as an alternative.
Self-Service Through CoreCast
For teams that prefer a hands-on approach, CoreCast offers an all-in-one platform for risk assessment. It streamlines data management and analysis, making it easier to stay on top of refinancing risks. The platform’s Underwriter engine supports various asset classes and investment strategies, enabling real-time collaboration. Meanwhile, the Portfolio Insights feature tracks metrics like exposure, asset allocation, market concentration, and risk-adjusted returns. Since portfolios are linked dynamically to the Underwriter, any changes in market conditions automatically update refinancing risk assessments.
CoreCast also includes a Pipeline Tracker, which provides real-time updates on deal statuses. This feature has been shown to reduce deal slippage by 30% over two quarters.
“With the Pipeline Tracker, we reduced deal slippage by 30% over two quarters. The visibility and accountability it provides are game-changers.”
The platform’s Forecasting Tools use historical data, market benchmarks, and customizable assumptions to predict future performance scenarios. Developed from practical use at The Fractional Analyst, these tools deliver vital insights into how market shifts might influence refinancing outcomes. CoreCast further simplifies workflows by aggregating data from multiple sources into a single dashboard. This eliminates the need for manual data consolidation and allows users to customize dashboards for different audiences.
“Before CoreCast, it took hours to consolidate financials from different systems. Now, we generate insights in minutes.”
CoreCast also incorporates advanced machine learning and automation to flag risks and opportunities as they arise. The Stakeholder Module centralizes information, linking it to live asset performance and generating templated reports to ensure stakeholders receive consistent, up-to-date insights.
“CoreCast transformed how we communicate portfolio performance to stakeholders. We now spend more time analyzing data, and less time assembling it.”
Both direct service from expert analysts and the self-service capabilities of CoreCast include complimentary financial models and tools for detailed refinancing analysis. Together, these options provide a scalable way to manage refinancing risk with precision and efficiency.
Conclusion
The five-step process outlined earlier serves as a solid foundation for managing refinancing risk in commercial real estate (CRE). Effectively addressing these risks requires a deliberate and structured approach that goes beyond simple financial evaluations. The steps - reviewing loan maturity timelines, assessing debt service coverage and borrower health, analyzing market trends, evaluating underwriting standards, and applying risk reduction strategies - work together to create a well-rounded risk management framework.
This approach is especially important in today's economic climate. Rising interest rates and clusters of loan maturities significantly heighten refinancing risks. For financial institutions managing commercial loan portfolios, these risks can directly impact credit quality and profitability. The interconnected nature of the steps allows lenders and investors to pinpoint borrowers facing similar pressures, whether those arise from broader economic conditions or industry-specific challenges.
These complexities highlight the need for advanced analytical tools. Managing refinancing risks - particularly for interest-only, highly leveraged, or revolving loans - requires more than basic spreadsheets. When dealing with a "maturity wall" of loans set to come due in a tough market, having access to the right tools and expertise is critical for making timely, well-informed decisions.
Modern tools simplify this process. Platforms like CoreCast, offering real-time insights and automated workflows, complement expert support to streamline what has traditionally been a manual and time-consuming task. These solutions enable faster, more accurate analysis, helping to mitigate risks effectively.
In a CRE market valued at over $1 trillion, relying on ad-hoc assessments is far too risky. A comprehensive risk management strategy not only minimizes potential losses but also enhances asset stability. By consistently applying these five steps and leveraging advanced tools and expertise, real estate professionals can confidently tackle refinancing challenges, safeguard their investments, and optimize returns.
FAQs
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Stress testing is a key method for assessing how a commercial real estate borrower or loan portfolio might hold up under challenging market conditions. By creating scenarios such as increasing interest rates, falling property values, or an economic downturn, it helps uncover potential risks and weak points.
This approach gives lenders and investors a clearer picture of the borrower's ability to handle future debt obligations. It also helps them prepare strategies to address refinancing challenges before they become critical. By offering a deeper understanding of how market changes could affect loan performance and repayment, stress testing supports smarter, more informed risk management.
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When evaluating a borrower's financial health for refinancing, it's essential to focus on a few key areas. Start with loan maturity timing, debt service coverage, and the performance of the underlying asset. These factors help paint a clear picture of the borrower's current position.
It's also important to examine the debt maturity schedule, current market liquidity, and refinancing costs. These elements can highlight potential risks tied to the refinancing process.
Keeping an eye on metrics like default rates and loss given default can offer additional insights into how well the borrower might handle refinancing. By considering these factors together, you can form a more comprehensive view of their financial health and the risks involved.
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Keeping underwriting practices in tune with shifting market conditions is key to assessing risks effectively and spotting new opportunities. Changes in factors like interest rates, property values, or tenant demand can have a major influence on how commercial real estate investments perform.
Regularly revisiting and refining underwriting strategies allows you to stay aligned with the current market, reduce potential losses, and take advantage of new prospects as they arise. Being proactive not only leads to better decision-making but also helps you stay ahead in the constantly changing world of commercial real estate.