Wednesday, October 7, 2009
Partial IOs - Holy Collateral Batman
Planting a timebomb in a local library is a felony. -Batman
In the CMBS universe, you historically stuck your transitional loans (going under a rehab, or buyout financing, non-stabilized properties) into a Floater, and your stabilized loans went into the larger, and more common, Conduit/Fusion universe. However, in later vintage deals we saw a lot of Partial IO loans - initially these were commonly used in a situation such as a New York Class A office building with 30% of it's tenant base on long-term leases at $48-60 psf expiring within 5 years of origination.
Let's make that our hypothetical example (based on a real loan). When the loan was underwritten in 2007 Class A Office rents in Midtown peaked around $120 psf. The loan was underwritten under the assumption that the 100% occupied trophy asset would re-lease the rolling tenants at $90 psf (to be conservative ;)) with a 1.2x DSCR. However, the debt service wouldn't get covered unless they did an IO loan, so the borrower and the lender agreed to do a Partial IO, where the borrower would pay just the IO portion for the first 5 years, and then roll it into an Amortizing loan starting at month 61, with a total amortization period of 360 months. The interest rate is 6.14%. They also have a mezz loan which is barely covering - the 1.2x DSCR is just for the senior piece.
Turns out 2009 Class A office rents are closer to $65 today, and have room to come down, so the stabilized levels never get met. It's covering the IO-only at 1.2x. At month 61, they roll to Amortization and the debt service goes up (roughly 18.9%), and the DSCR drops to 1.009x on the senior, and their losing money once you factor in the Mezzanine loan.
Take the same hypothetical loan at a 5% interest rate (a 28.8% increase in debt service, your denominator), and your post-IO DSCR is 0.93x on the senior. Take it up to a 7% interest rate (a 14% increase in debt service), and life still is not good with a 1.05x DSCR on the senior.