Real Estate Review Chapter 16

Summary The majority of commercial properties require debt financing that is adapted to the specifics of the scenario. Despite the fact that some of the same organizations (such commercial banks) that originate residential loans also offer financing for commercial property, the loan terms are very different. For instance, commercial mortgages often have shorter terms and have prepayment restrictions or fees. Long-term (permanent) commercial mortgages are typically repaid using one of three repayment options: interest-only loans, partially amortizing loans, or completely amortizing loans. The most typical mortgage structure is a fixed-rate, partially amortizing mortgage with balloon payments, however commercial mortgages frequently include adjustable or fluctuating interest rates. Due to lockout clauses, prepayment penalties like yield-maintenance agreements or defeasance, or both, fixed-rate commercial mortgages typically do not let borrowers to freely prepay at par. In general, floating-rate loans can be repaid at par without incurring penalties. For investors and property owners to consider, participation mortgages and sale-leaseback finance are alternative financing formats. Investors must first choose the best financing structure before deciding on their preferred loan size. A project's equity returns are amplified by borrowed money. Investors can generally boost their expected returns by adopting greater loan-to-value ratios, or more financial leverage. But by doing so, they also raise the possibility that equity returns will be unpredictable and that net operating income won't be enough to meet the mortgage payment obligation. Financial risk is a common term used to describe the latter issue. Commercial borrowers must also decide whether to prepay and whether to default after the loan is originated. When making decisions in either scenario, net present value estimates should be used as a reference. Of course, when choosing the default choice, it is important to account for all potential costs, such as a decreased ability to get financing in the future. Borrowers can submit loan requests directly to commercial banks, life insurance firms, or other direct lenders if they want to buy or refinance an existing commercial property. Requests for commercial loans can also be made through mortgage bankers and brokers, who focus on creating loan applications that satisfy the needs of both borrowers and lenders. Compared to home loans, the commercial loan underwriting process is more difficult and concentrates more on the asset utilized as loan collateral. The method through which equity investors submit a request for and receive permanent financing to buy or refinance an existing commercial property differs depending on the lender, the kind and caliber of the property, and any prior connections the lender may have with the borrower. Normally, borrowers present a loan package to a lender with the possible assistance of a mortgage broker (or lenders). The loan submission package's objective is to give lenders the data they require to rapidly assess the borrower's request. The lender either rejects the loan opportunity based on the data in the loan submission package or provides a preliminary quote outlining the key elements of the proposed loan. After then, the borrower can decide whether to accept or reject the lender's offer or, in some situations, try to bargain for better loan conditions. If the borrower and the lender can agree on the fundamental parameters of the loan, the lender will prepare the loan application before sending it to the borrower for signature. The size of the loan request, the type of property being used as collateral (such as an office or apartment), and whether the loan will be held in the lender's portfolio or sold in the secondary market where it will be used as collateral for the issuance of a commercial mortgage-backed security all affect the length and specifics of the loan application. The borrower is often asked to pay a nonrefundable loan processing fee and one or more deposits, including a "good faith" deposit, which can amount to 1-2 percent of the loan amount, when the loan application is signed. At loan closing, the borrower normally receives their good faith deposit back. With the signed application, loan processing fee, and borrower deposits, the lender is confident the borrower intends to close the loan. The lender’s required due diligence begins once the loan application is signed. In part, the lender performs due diligence to make sure the potential borrower did not misrepresent the property in any way in the original loan submission package. The lender will also collect and analyze more information on the building and the recent operating performance of the property. If the loan application sur - vives the due diligence process, the lender must decide whether or not to finalize the loan and schedule a closing date. Test Problems 1. Due-on-sale clauses are included in commercial mortgages primarily to protect lenders from: a. Interest rate risk. b. Default risk. c. Reinvestment risk. d. Prepayment risk. 2. Consider a 30-year, 7 percent, fixed-rate, fully amortizing mortgage with a yield maintenance provision. Relative to this mortgage, a 10-year balloon mortgage with the same contract interest rate and yield maintenance provisions will primarily reduce the lender’s: a. Interest rate risk. b. Default risk. c. Reinvestment risk. d. Prepayment risk. 3. An interest-only balloon mortgage loan is commonly referred to as a: a. Mini-perm loan. b. Mezzanine loan. c. Land acquisition loan. d. Bullet loan. 4. The acquisition price of a property is $380,000. The loan amount is $285,000. If the property’s NOI is expected to be $22,560, operating expenses $12,250, and the annual debt service $19,987, the debt yield ratio (DYR) is approximately equal to: a. 0.059 or 5.9%. b. 0.079 or 7.9%. c. 0.0701 or 7.0%. d. 0.0526 or 5.3%. e. None of the above. 5. Which of the following statements is most accurate? a. Joint ventures usually increase the amount of equity capital the developer/borrower must invest in the project. b. Joint ventures usually decrease the amount of equity capital the developer/borrower must invest in the project. c. Joint ventures give the developer/borrower a priority claim on the property’s cash flows. d. Joint ventures increase the developer/borrower’s exposure to the risk of property price fluctuations. 6. Commercial mortgage borrowers may decide to prepay the principal on their loan even if they face prepayment penalties. One way that lenders protect themselves from prepayments in such circumstances is by requiring the borrower who prepays to purchase for the lender a set of U.S. Treasury securities whose coupon payments replicate the cash flows the lender will lose as a result of the early retirement of the mortgage. This process is referred to as: a. Lockout. b. Yield-maintenance. c. Defeasance. d. Curtailment. 7. Using financial leverage on a real estate investment can be for the purpose of all of the following except: a. Greater diversification. b. Greater expected return on equity. c. Being able to acquire the property. d. Reduction of financial risk for the leveraged investment. 8. Which of these ratios is an indicator of the financial risk for an income property? a. Debt coverage ratio. b. Loan-to-value ratio. c. Equity dividend rate. d. Both a and b, but not c. e. All three, a, b, and c. 9. The acquisition price of a property is $380,000. The loan amount is $285,000. If the property’s NOI is expected to be $22,560, operating expenses $12,250, and the annual debt service $19,987, the debt coverage ratio (DCR) is approximately equal to: a. 0.89. b. 1.13. c. 1.84. d. 1.74. e. None of the above. 10. With a mezzanine loan: a. the mezzanine lender has a lien on the property that is subordinate to the senior lien holder’s position. b. the borrower pledges the same property as collateral for the mezzanine loan that was pledged as collateral for the first mortgage. c. the borrower’s promise to pay is secured by the equity interest in the borrower’s limited partnership or limited liability company. d. the mezzanine lender has a more difficult time foreclosing than would be the case with a second mortgage. Study Questions 1. Discuss several differences between long-term commercial mortgages and their residential counterparts. 2. Answer the following questions on financial leverage, value, and return: a. Define financial risk. b. Should the investor select the origination LTV that maximizes the expected return on equity? Explain why or why not. 3. Distinguish between recourse and nonrecourse financing. 4. Explain lockout provisions and yield-maintenance agreements. Does the inclusion of one or both of these provisions affect the borrower’s cost of debt financing? Explain. 5. Assume the annual interest rate on a $500,000 seven-year balloon mortgage is 6 percent. Payments will be made monthly based on a 30-year amortization schedule. a. What will be the monthly payment? b. What will be the balance of the loan at the end of year 7? c. What will be the balance of the loan at the end of year 3? d. Assume that interest rates have fallen to 4.5 percent at the end of year 3. If the remaining mortgage balance at the end of year 3 is refinanced at the 4.5 percent annual rate, what would be the new monthly payment assuming a 27-year amortization schedule? e. What is the difference in the old 6 percent monthly payment and the new 4.5 percent payment? f. What will be the remaining mortgage balance on the new 4.5 percent loan at the end of year 7 (four years after refinancing)? g. What will be the difference in the remaining mortgage balances at the end of year 7 (four years after refinancing)? h. At the end of year 3 (beginning of year 4), what will be the present value of the difference in monthly payments in years 4–7, discounting at an annual rate of 4.5 percent? i. At the end of year 3 (beginning of year 4), what will be the present value of the difference in loan balances at the end of year 7, discounting at an annual rate of 4.5 percent? j. At the end of year 3 (beginning of year 4), what will be the total present value of lost payments in years 4–7 from the lender’s perspective? k. If the mortgage contains a yield-maintenance agreement that requires the borrower to pay a lump sum prepayment penalty at the end of year 3 equal to the present value of the borrower’s lost payments in years 4–7, what should that lump sum penalty be? 6. Consider the stand-alone corner locations favored by Walgreens for locating their drugstores. In most cases, Walgreens does not own these properties. Instead, they lease the properties on a long-term basis from institutional owners. What does Walgreens gain by leasing instead of owning? What do they lose? 7. Consider the following table of annual mortgage rates and yields on 10-year Treasury securities: Year Mortgage Rate (%) 1990 9.98 10-Year U.S. Treasury Yield (%) 8.48 1991 9.76 7.87 1992 9.01 7.02 1993 7.90 5.90 1994 8.66 6.97 1995 8.13 6.69 1996 7.79 6.39 1997 7.63 6.36 1998 6.85 5.23 1999 7.59 5.57 2000 8.18 6.07 2001 7.25 4.95 2002 6.65 4.64 2003 5.70 4.03 2004 5.67 4.31 5.43 4.25 2005 a. What was the average annual spread on mortgage rates relative to 10-year Treasury securities over the 1990– 2005 period? b. What was the correlation between annual mortgage rates and Treasury yields over the 1990–2005 period? (Use your financial calculator or the statistical functions in Excel.) 8. List and briefly describe the typical items included in a commercial mortgage loan submission package. 9. You have decided to purchase an industrial warehouse. The purchase price is $1 million and you expect to hold the property for five years. You have narrowed your choice of debt financing packages to the following two alternatives: ∙ $700,000 loan, 6 percent interest rate, 30-year term, annual, interest-only payments (the annual payment will not include any amortization of principal), and $50,000 in up-front financing costs. ∙ $750,000 loan, 6 percent interest rate, 30-year term, annual, interest-only payments. No up-front financing costs. What is the difference in the present value of these two loan alternatives? Assume the appropriate discount rate is 6 percent. 10. You are considering the purchase of an industrial warehouse. The purchase price is $1 million. You expect to hold the property for five years. You have decided to finance the acquisition with a $700,000 loan, 6 percent interest rate, 30-year term, and annual interest-only payments (i.e. the annual payment will not include any amortization of principal). There are $50,000 in up-front financing costs. You estimate the following cash flows for the first year of operations: $135,000 Effective gross income 27,000 Operating expenses $108,000 NOI a. Calculate the overall rate of return (or “going-in cap rate”). b. Calculate the debt coverage ratio. c. What is the largest loan that you can obtain (holding the other terms constant) if the lender requires a debt service coverage ratio of at least 1.2? 11. Distinguish among land acquisition loans, land development loans, and construction loans. How would you rank these three with respect to lender risk? 12. Discuss the potential advantages of a mini perm loan from the perspective of the developer/investor, relative to the separate financing of each stage of the development. 13. You are considering purchasing an office building for $2,500,000. You expect the potential gross income (PGI) in the first year to be $450,000; vacancy and collection losses to be 9 percent of PGI; and operating expenses and capital expenditures to be 42 percent of effective gross income (EGI). You will finance the acquisition with 25 percent equity and 75 percent debt. The annual interest rate on the debt financing will be 5.5 percent. Payment will be made monthly based on a 25-year amortization schedule. a. What is the implied first year overall capitalization rate? b. What is the expected debt coverage ratio in year 1 of operations? c. If the lender requires the DCR to be 1.25 or greater, what is the maximum loan amount? d. What is the debt yield ratio?