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

Question

Looking at an LP position in a prime CBD asset and the debt is what I can't get comfortable with. Details as presented:

$78m purchase, 91 percent leased, in-place NOI $5.65m, so about a 7.25 percent cap going in. $48m bridge loan, 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.

Sponsor's model exits year five at a 6.5 percent cap on $7.1m of NOI, which is $109m. Fine, that's their assumption and I can discount it.

What I can't model is the extension test. At SOFR 4.30 the all-in is 7.55 percent, so debt service on $48m is about $3.62m and the 1.15x test needs $4.17m of NOI. They're at $5.65m today so there's headroom. But if two of the four largest tenants roll in year three, which they do, and NOI drops to $4.4m while the rate hasn't moved, I'm at 1.21x and one bad renewal from failing.

If the test fails, my understanding is the loan matures and the sponsor either brings a paydown, refinances into whatever the market gives, or sells into it. All three of those are equity events for me.

How do you actually put a number on that risk when the offering just says extensions available? Is there language you look for, and does a rate cap help me here at all, since the cap protects the rate but 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're right that it only solves half of it. What I've started doing is building 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 I'd want read by counsel 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 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 your 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 doesn't. 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?

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