1. Chapter 16 Commercial Mortgage Types and Decisions McGraw-Hill/IrwinCopyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 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

3. 16-3 Commercial Mortgage Loans Usually a partially amortized “balloon” mortg age  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

4. 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

5. 16-5 Commercial Mortgage “Spreads” over Treasuries Mortgage rates highly correlated with 10-Year Treasury Securities

6. 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

7. 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

8. 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

9. 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

10. 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.

11. 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)

12. 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)www.fanniemae.comwww.freddiemac.com

13. 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

14. 16-14 Adding Mezzanine to the Capital Stack

15. 16-15 Average Terms on Commercial Mortgages– RealtyRates.com (Exhibit 16-4) RealtyRates.com

16. 16-16 Important “Underwriting” Ratios Debt coverage ratio:  indicator of “cash flow cushion” from lender’s perspecti ve 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

17. 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

18. 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)

19. 16-19 Financing Income-Producing Property: Borrower Perspective

20. 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 = PV OLD – PV NEW – Refi Cost – Prepay Penalty

21. 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).

22. 16-22 Obtaining a Commercial Mortgage Loan The Loan Submission Package  Loan application from borrower contains Financial statements Credit reports Borrower’s experience resume

23. 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

24. 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

25. 16-25 Loan Underwriting: Crunching the Numbers

26. 16-26 Gatorwood Before-Tax Cash Flow from Operations

27. 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

28. 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 PV Pmt i i n n FV 360 7.625 $1,018,000 0 $11,878,124.05

29. 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 PV Pmt i i n n FV 360 7.625/12 $84,333.33 0 $11,985,600.86

30. 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%

31. 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

32. 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

33. 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

34. 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

35. End of Chapter 16