Post on 25-Dec-2015
Chapter 16
Commercial Mortgage Types and Decisions
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
16-2
“Commercial” Loans vs Home Loans Commercial mortgages & notes not as
standardized as home loans Although this was changing with growth in commercial
mortgage-backed securities (CMBS) market Documents are longer & more complex Often no personal liability:
Legal borrower often is a single asset corporation Actual investors are shielded from liability Credit enhancement sometimes is required, especially
by commercial banks
16-3
Commercial Mortgage Loans
Usually a partially amortized “balloon” mortgage 25-30 year amortization of principle 5-10 year loan maturity Balance of loan at maturity must be refinanced or paid
off with a “balloon” payment
16-4
Attractions of Balloon Mortgage to Lender Reduces interest rate risk Reduces default risk
Default risk is generally much greater for commercial mortgage loans than home loans Seldom personal liability No FHA/PMI insurance Borrowers are more “ruthless” about exercising their
default options
16-5
Commercial Mortgage “Spreads” over Treasuries
Mortgage rates highly correlated with 10-Year Treasury Securities
16-6
Restrictions on Prepayment
Lock-out: Prohibition against prepayment for up to 5 years
Prepayment penalties: Percentage of loan: Say, 2-4% of loan balance Yield maintenance penalty: Borrower must pay
lender PV of losses due to prepayment Defeasance penalty: Borrower must replace
mortgage loan with a set of U.S. Treasury securities that produce cash flows equivalent to those on the paid-off mortgage Recently has become most common form of prepayment
penalty
16-7
Other Forms of Commercial Mortgage Financing
Floating (i.e., adjustable) rate mortgage Index rate most commonly is LIBOR
Installment sale financing Buyer makes installment payments to seller Seller only pays capital gain taxes over time in
proportion to the annual payments received
16-8
Other Forms of Commercial Mortgage Financing - continued
Joint Venture Lender likely:
provides a mortgage loan to project provides equity capital receives mortgage interest plus equity cash flows
Borrower likely: provides the project provides expertise & management effort
16-9
Joint Venture - continued
Often between a developer/organizor of a large project and a:
pension fund life Insurance company REIT
Institution provides construction financing and/or long-term mortgage, in addition to some of required equity capital
Institution’s share of operating & sale cash flows are negotiated
16-10
Other Forms of Commercial Mortgage Financing (continued) Sale-leaseback
Owner-user sells property to a long-term investor such as a pension fund limited liability company Tenancy in common
User leases property back from the investor(s) & occupies it under long-term net lease.
16-11
Sale-Leaseback - continued
User benefits: Lease payment is deductible for income taxes Equity capital is freed up to invest in core business of
company
Investor benefits: Can be relatively safe investment (depending on
credit worthiness of tenant). Inflation hedged (especially if lease payments
increase with inflation)
16-12
Other Forms of Commercial Mortgage Financing - continued FHA insured loans for low & moderate income
multifamily housing. Freddie Mac & Fannie Mae multifamily lending
programs Many targeted to low & moderate income housing See Fannie & Freddie websites (www.fanniemae.com
and www.freddiemac.com)
16-13
Other Forms of Commercial Mortgage Financing - continued
Mezzanine Debt: Supplements underlying first mortgage debt Sometimes is a second mortgage loan (i.e., secured by
the property) More often is a non-mortgage loan secured by a
pledge of borrower’s ownership interest If borrower defaults, mezz lender takes over borrower’s
ownership position…giving them more control
16-16
Important “Underwriting” Ratios
Debt coverage ratio: indicator of “cash flow cushion” from lender’s
perspective
DCR = NOI÷DS
where:NOI is first year NOI
DS is annual debt service (12 monthly payments)
Lender’s want DCR to be as high as possible, but usually > 1.20
16-17
Important “Underwriting” Ratios
Loan-to-value ratio: indicator of equity incentive to maintain the loan
LTV = Loan÷Value
The higher the initial LTV, the greater the probability of subsequent default, all else equal
16-18
The Leveraging Question (How Much Debt?) Reasons for use of debt by investors:
“Magnify” equity returns Diversify the use of one’s equity
Financial risk: Risk of default on mortgage loan. Risk of negative cash flow Increases with greater leverage.
Leverage also increases variability of equity returns (more on this in Chapter 19)
16-20
Refinancing & Default with Commercial Mortgage Loans
Refinancing involves a NPV decision Even more focused on NPV than home mortgage
refinancing Bigger finance issues Fewer non-financial considerations
Often must account for a prepayment penalty NPV = PVOLD – PVNEW – Refi Cost – Prepay Penalty
16-21
Refinancing & Default with Commercial Mortgage Loans
Default is the signature risk of commercial mortgages. Borrower seldom can cover the loan payment for a
crippled commercial property. Borrower often is in a non-recourse position (god
for the borrower, bad for the lender).
16-22
Obtaining a Commercial Mortgage Loan The Loan Submission Package
Loan application from borrower contains Financial statements Credit reports Borrower’s experience resume
16-23
Obtaining a Commercial Mortgage Loan The Loan Submission Package, continued
Property description Legal description Detailed physical description
Photos including aerial shots Survey Site plan Structure drawings & specifications
Market analysis Cash flow pro forma (projections) Market value appraisal
16-24
The Lender’s Decision: Loan Underwriting “Qualitative” considerations
Property type Location Tenant quality Lease terms Property management Building quality Environmental issues Borrower quality
16-27
Loan Underwriting: Crunching the Numbers Lender’s focus is usually on projected NOI over
next 12 months Debt coverage ratio:
DCR = NOI÷DS For Gatorwood:
DCR = $1,272,500÷$857,038 = 1.5 Maximum loan:
Maximum debt service = NOI÷ Required DCR For Gatorwood:
Maximum debt service = $1,272,500÷1.25 = $1,018,000
16-28
Loan Underwriting: Determining Maximum Loan Maximum Loan - continued
Assume the lender’s terms would be Term for amortization: 30 years Interest rate: 7.625
PVPV PmtPmtiinn FVFV
360 7.625 $1,018,000 0
$11,878,124.05
16-29
Loan Underwriting: Determining Maximum Loan Maximum loan continued (monthly pmt)
Monthly debt service:MDS = DS÷12 = $1,018,000÷12 = $84,333.33
Assume the lender’s terms would be Term for amortization: 30 years Interest rate: 7.625
PVPV PmtPmtiinn FVFV
360 7.625/12 $84,333.33 0
$11,985,600.86
16-30
Loan Underwriting: Break-Even Ratio Break-even Ratio
BER = (OE + CAPX + DS)÷PGI Indicates required occupancy level (approx.) Gatorwood example:
BER = (400,000 + 37,500 + 857,038)
÷ 1,900,000
= 0.681 or 68%
16-31
Due-diligence: review & verification of the facts and analysis supplied by borrower in loan submission package Analyze rent roll & individual existing leases Analyze history of OE and CAPX Verify other facts (check for credibility and consistency) Check for missing or undisclosed information Verify borrower’s computations and analysis.
Loan Underwriting: Due-Diligence
16-32
45-90 days after receipt of “package” Lender often offers buyer/borrower a “rate lock”
option for a fee Protects borrowers from a rise in interest rates before
the loan is actually closed
Loan Commitment
16-33
Construction and Development Financing Land acquisition financing
Finance purchase of raw land, often on urban fringe
Land development loan Finance installation of improvements to the land
(sewers, utilities, etc.)
Construction loan Finance vertical construction
Mini-perm loan Provide financing for the development phase, plus a
short-term permanent loan upon completion of project
16-34
Construction and Development Financing Land acquisition financing
VERY risky; most traditional lenders will not touch
Land development loan If the land is ready for development, presumably
demand for the finished product is less uncertain
Construction loan Arguably, the collateral securing a construction loan is
more valuable than the collateral securing land acquisition & development loans