How do you stress test a bridge loan extension test on a prime office LP position?

Question

Consider an LP position in a prime CBD office asset where the debt is the part worth stress testing. As presented: a $78m purchase, 91 percent leased, in place NOI of $5.65m, so about a 7.25 percent cap going in. The debt is a $48m bridge loan at 62 percent LTC, SOFR plus 325, interest only, 3 year initial term with two 12 month extension options. The extensions require a 1.15x debt service coverage test at the then current rate plus a fee of 25 basis points each. The sponsor's model exits year five at a 6.5 percent cap on $7.1m of NOI, which is $109m. That is their assumption and it can be discounted. The extension test is the part that resists modeling. At SOFR 4.30 the all in rate is 7.55 percent, so debt service on $48m is about $3.62m and the 1.15x test needs $4.17m of NOI. At $5.65m today there is headroom. But if two of the four largest tenants roll in year three, which in this scenario they do, and NOI drops to $4.4m while the rate has not moved, coverage sits at 1.21x and the deal is one bad renewal from failing. If the test fails, the loan matures and the sponsor either brings a paydown, refinances into whatever the market gives, or sells into it. All three are equity events for the LP. How does an investor actually put a number on that risk when the offering just says extensions available? Is there language to look for, and does a rate cap help at all, given that the cap protects the rate while the test is against NOI as much as rate?

devon_pierce · Answer

The rate cap helps the numerator of your test and does nothing for the tenant roll, so you are right that it only solves half of it. The better approach is to build the test as a grid rather than a case: SOFR across say 3.5 to 5.5 percent on one axis, NOI from 80 to 110 percent of in-place on the other, and shading every cell that comes in under 1.15x. On your numbers the failure zone starts showing up around 85 percent of in-place NOI at anything over 8 percent all-in, which is not a remote corner of that grid. The language worth having counsel read is whether the extension is a right on satisfying the test or subject to lender approval, whether a paydown to cure is expressly permitted and capped, and whether "then-current" means the actual rate or a stressed underwriting rate the lender picks. That last one has bitten people, because some documents test at an assumed constant rather than the real coupon. Also, whose NOI? Lender-adjusted NOI usually deducts a management fee and a TI and leasing reserve even if the sponsor's model does not. That deduction alone can be $1.75 to $2.25 per square foot and it comes out of the numerator of your test.

jordan_ellis2 · Answer

The piece I'd chase is the year three rollover itself, because everything downstream of it is arithmetic. Which two tenants, how many square feet, what are they paying versus current market asking, and has the broker had any renewal conversation yet? If they're above market on rents signed in a different era, the renewal is a rent cut plus a TI check and your $4.4m case is optimistic.

I don't have a good answer to your actual question. Every deck I've read says extensions available and none of them show the test. I've started asking for the loan agreement itself rather than the summary, and about half the time the sponsor gets vague, which is its own data point.

How do you stress test a bridge loan extension test on a prime office LP position?

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