"Commercial Mortgage: Types, Attractions, and Financing", Study notes of Real Estate Management

Download "Commercial Mortgage: Types, Attractions, and Financing" and more Study notes Real Estate Management in PDF only on Docsity! 1 Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Fin 5413 Commercial Mortgage Types and Decisions 17-2 “Commercial” Loans vs Home Loans Commercial mortgages and notes are not as standardized as home loans • Although this is changing with growth in commercial mortgage-backed securities market Documents are longer and more complex. Often no personal liability: • Legal borrower often is a single asset corporation. • Actual persons are shielded from liability. • Credit enhancement sometimes is required. 17-3 Commercial Mortgage Loans Usually a partially amortized “balloon” mortgage. • 25 to 30 year amortization of principle. • 5 to 10 year maturity • Balance of loan at maturity must be refinanced or paid off with a “balloon” payment Bullet loans are non amortizing for with a fixed term at which point the principal is repaid 17-4 Attractions of Balloon Mortgage to Lender Reduces interest rate risk. Reduces default risk. • Default risk is much greater for commercial mortgage loans than for home loans. • As with residential lending, default risk varies over time • 7% delinquent in late 1992 • 0.1% delinquent in 2004 • 1.05% in 3rd quarter of 2005 • Actual yield to lender will generally be lower than scheduled yield due to defaults 17-5 Commercial Mortgage “Spread” over “Treasuries” Exhibit 17-2 3% 4% 5% 6% 7% 8% 9% 10% 11% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 Survey Rate 10-Year 10-Year US Treasury Yield Exhibit 17-2 3% 4% 5% 6% 7% 8% 9% 10% 11% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 Survey Rate 10-Year 10-Year US Treasury Yield Mortgage rates highly correlated with 10-Year Treasury Securities 17-6 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 producing equivalent cash flows • Recently has become most common form of prepayment penalty • This replaces a risky promised set of CF’s with a risk free set of CF’s so its good for a lender 2 17-7 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. • Seller only pays capital gain taxes over time in proportion to amount of the price received. 17-8 Other Forms of Commercial Mortgage Financing - continued Joint Venture • Lender: • Provides a mortgage loan • Provides additional equity investment. • Receives mortgage interest plus equity cash flows. • Borrower: • Provides the project. • Provides expertise and management effort. • Provides some of the equty 17-9 Joint Venture - continued Usually between a developer 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 17-10 Other Forms of Commercial Mortgage Financing - continued Land Sale-leaseback: • Investor owns land and mortgage on building. User owns building subject to mortgage and p pays a land lease (both deductible for taxes) Sale-leaseback • User sells property to a long-term investor. • Pension fund. • Trust. • Life insurance company. • User leases property back from the investor and occupies it under long-term net lease. 17-11 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 safe investment (depending on credit worthiness of tenant). • Inflation hedged (especially if lease payments increase with inflation). 17-12 Other Forms of Commercial Mortgage Financing - continued Mezzanine Debt (growing in popularity): • 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 ownership shares • If borrower defaults lender takes over the borrower’s ownership position rather than having a lien on the real estate (which the first mortgage holder has) 5 17-25 Obtaining a Commercial Mortgage Loan The Loan Submission Package • Loan application with the exact terms proposed. • Financial statement • Credit report • Borrower experience resume • Property description • Legal description • Easements and encroachments • Environmental concerns • Detailed physical description • Photos and aerial photos • Survey • Site plan • Structure drawings and specifications 17-26 The Loan Submission Package - continued • Cash flow pro forma • Existing cash flows and rent rolls (leases) if available • DCF analysis • Appraisal – independent and state certified 17-27 Obtaining a Commercial Mortgage Loan Sources of loans (direct submission) • Larger commercial bank • Large thrift institution • Other direct sources including pension funds and life insurance companies 17-28 Sources of Commercial Loans- continued • “Correspondent” lender • Mortgage banker • Mortgage broker • Presents loan “package” to: • Life insurance companies • Pension funds • Trusts • Large banks • Credit companies (GE Capital, Ford, other) • Receives fee of one-half to one percent of loan. 17-29 The Lender’s Decision: Loan Underwriting “Qualitative” considerations • Property type • Location • Tenant quality • Lease terms • Property management • Building quality (Age, class, deferred maintenance?) • Environmental issues • Borrower quality 17-30 Loan Underwriting: Crunching the Numbers Exhibit 17-6 Assumptions for a Loan on Gatorwood Apartment Complex Input Assumption Number of units 296 units with average monthly rent of $534.91 Purchase price $13,375,000 Vacancy and collection losses 10% per year Operating expenses $400,000 in year 1 Capital Expenditures $37,500 in year 1. Expenditures are reserved for in calculation of NOI (i.e. an above line treatment) Financing: Loan amount $10,000,000 (equals 74.7664% of price) Interest rate 7.625% Amortization schedule 30 years, annual payments Loan term 10 years Annual Payment $857,037.69* * The calculator keystrokes for finding the annual payment are: N=30; I/YR= 7.625, PV=10,000,000; PMT=?; and FV=0. Loan payment calculations are discussed in detail in Chapter 15. 6 17-31 Gatorwood Before-Tax Cash Flow from Operations Exhibit 17-7 Gatorwood Apartment Complex Before-Tax Cash Flows From Annual Operations 1 Potential Gross Income (PGI) $1,900,000 - Vacancy and Collection Loss (VC) 190,000 = Effective Gross Income (EGI) 1,710,000 - Operating Expenses (OE) 400,000 - Capital Expenditures (CAPX) 37,500 = Net Operating Income (NOI) 1,272,500 - Debt Service (DS) 857,038 = Before-Tax Cash Flow $415,462 17-32 Loan Underwriting: Crunching the Numbers Focus on first-year NOI Debt coverage ratio: • DCR = NOI÷DS • For Gatorwood: DCR = $1,272,500÷$857,038 = 1.5 Maximum loan: Max debt service = NOI÷ Required DCR • For Gatorwood: Max debt service = 1,272,500÷1.25 = $1,018,000 17-33 Loan Underwriting: Determining Maximum Loan Maximum Loan - continued • Assume the lender’s terms would be • Term for amortization: 30 years • Interest rate: 7.625 (Annual) PVPV PmtPmtiinn FVFV 30 7.625 $1,018,000 0 $11,878,124.05 17-34 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 $84,333.33 0 $11,914,958.34 / 13,175,000 = 90.4% LTV 17-35 Loan Underwriting: Break-Even Ratio Break-even Ratio: when income = expenses • BER * PGI = (OE + CAPX + DS) • Gives Required occupancy level (approx.) • Gatorwood example: BER = (400,000 + 37,500 + 857,038) ÷ 1,900,000 = 0.681 or 68% 17-36 Due-diligence: review and verification of the facts and analysis in the loan submission package. • Verify facts (check for credibility and consistency). • Check for missing or undisclosed information. • Verify computations and analysis. Loan commitment • 45 to 90 days after receipt of “package” • Lender often offers buyer/borrower a “rate lock” option for a fee. • This protects borrowers from a rise in interest rates before the loan is actually closed • Lenders can hedge their lock agreements if they wish (called “pipeline” hedging) Loan Underwriting: Lender’s Decision 7 17-37 Construction and Development Financing Land acquisition financing • Finance the purchase of raw land Land development loan • Finance the installation of improvements to the land (sewers, utilities, etc.) Construction loan • Finance the vertical construction Mini-perm loan • A permanent loan with a short term 17-38 Summary For commercial lending, the building produces the income that is used to pay off the lien The ability of the building to produce cash flows is what the lender evaluates Priced off the 10 year Treasury Securities (2-3% average spread) Loans typically are balloon loans with a 5-7 year term and 25-30 year amortization Prepayment penalties common Underwriting focuses on DCR and LTV CMBS is a growing source for placement of commercial mortgages