Commercial Mortgages: Market, Types and Underwriting Decisions

Typology of mortgages, Overview of the mortgage industry

Mortgages

Residential

Commercial

Govt Insured

Conventional

Permanent

Construction and Development

Construction and Development Financing

Land acquisition financing Land development loan Construction loan Mini-perm loan

The classical construction finance structure:

Phase:
Construction Lease-Up Stabilized Operation

Financing:

C.O.

Construction Loan

Bridge Loan

Permanent Mortgage

Source:
Commercial Bank Comm. Bank Insur Co. Via Mortg Brkr or Mortg Banker: Life Insur. Co. Pension Fund Conduit
CMBS

Construction lender wont approve construction loan until permanent lender has conditionally approved a take-out loan.

Sources of Commercial Mortgage Financing

Commercial banks
Life insurance companies Pension funds Conduit lenders Correspondent lenders

The Capital Stack

Equity } 5% } 5%

Equity

} 35%

Preferred Equity

Sub. Mezzanine Loan }10%

Sen. Mezzanine Loan }10% Sub. B-Note Sen. B-Note }10% }10%

First Mortgage } 65%

Senior Debt }50%

Traditional and Modern

Modern (before 2008)

Commercial Loans vs. Residential Loans

Commercial mortgages and notes are not standardized. 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.

Default and Foreclosure

Default is a violation of a clause or covenant in the mortgage or note agreement
Litigious settlement
Sue for specific performance Sue for damages Sue for foreclosure

Nonlitigous settlement
Exercise forbearance (workout, deed in lieu of foreclosure, restructuring (partners and/or terms))

Costs of Foreclosure
Legal and administrative (can be 10% or more of loan) Deterioration of property value Reputation effects Regulatory effects (write-down) Lost revenue (interest during the process)

Priority of Claims in Foreclosure

Lien Priority established by Date of Recording, except:
Property Tax Lien comes first Sometimes Mechanics Liens Explicit Subordination Clause Bankruptcy Proceedings may modify debtholder rights First Mortgage (earlier recording) = Senior Debt 2nd (etc) Mortgage = Junior Debt

Redeem up, Foreclose down

Senior Lien Holders obtain their claim (to the extent foreclosure sale proceeds and their priority allows), even if they did not bring the suit. Junior Lien Holders lose claims after foreclosure, provided they are included in the foreclosure suit. Lien Holder brining foreclosure suit normally buys the property in the foreclosure sale, for amount sufficient to cover its claim.

Permanent Commercial Mortgage Market

The primary market is dominated by commercial banks and life insurance companies. In recent years, the size of the CMBS market has grown dramatically. This is the secondary market. Commercial mortgages are typically 5- to 10years, and often include a balloon payment. Permanent commercial mortgages are often nonrecourse loans.

Permanent Commercial Mortgage Market

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 - 1% of loan

With much of the debt being securitized

Investment Grade Securities

AAA AA A BBB

Commercial Real Estate Asset

Non-Investment Grade Securities

Payments

BB Debt

Unrated

Equity

Equity

Loans

Commercial Mortgage Securitization

Servicer
(Master Svcr, Sub-Svcrs)

Trustee
Oversees Pool

Collects CF

Special Sevicer
Deals with defaults, workouts

CMBS Securitization

Mortgage Yield: The Components of Ex Ante Returns

Exhibit 19-7: Components of commercial mortgage total yield:

Total Yield Illiq

Due to illiquidity in individual bonds, mortgages. Due to expectation of default (not risk of default)
Yld Degr

Default Risk

Due to risk of default (not expectation of default):

Yld Crv

Yield curve (premium of LT over ST T-Bonds), reflects interest rate risk, liquidity preference (habitat), mkt expectations about fut. int.rates If inflation rate expected in short run,. Pure time-value-of-money component of required return. Varies w Fed policy & supply/demand for short term capital.

Infla

Real rf

Other Forms of Commercial Mortgage Financing

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.

Joint Venture - continued

Usually between a developer of a large project and:
Pension fund. Life Insurance company. REIT

Institution provides the construction financing and/or long-term financing, in addition to some of required equity capital Shares and claims to operating and sale cash flows are negotiated

Other Forms of Commercial Mortgage Financing - continued

Sale-leaseback
User sells property to a long-term investor.
Pension fund. Trust. Life insurance company.

Leases the property back from the investor and occupies it under long-term net lease.

Sale-Leaseback - continued
User benefits:
Lease payment is deductible for income taxes. Equity capital remains available for core business.

Investor benefits:
Can be extremely safe investment. Inflation hedged (especially if lease payments increase with inflation).

Other Forms of Commercial Mortgage Financing - continued

Mezzanine Debt:
Supplements underlying first mortgage debt. Sometimes is a second mortgage loan. Often is a non-mortgage loan secured by a pledge of ownership shares.

Other Forms of Commercial Mortgage Financing - continued

Participation loan:
Higher loan-to-value ratio Lender receives fixed interest plus:
Share of the cash flow from operations. Share of the proceeds from sale.

Other Forms of Commercial Mortgage Financing - continued

FHA insured loans for low and moderate income multifamily housing. Freddie Mac and Fannie Mae multifamily lending programs
Many targeted to low and moderate income housing.

Important Underwriting Ratios

Debt coverage ratio: indicator of the cash flow cushion. DCR = NOIDS
NOI is first year NOI DS is annual debt service (12 monthly payments)

Loan-to-value ratio: indicator of equity incentive to maintain the loan. LTV = LoanValue

Important Underwriting Ratios

Break-even Ratio
BER = (OE + CAPX + DS)PGI
Gives Required occupancy level (approx.)

Variables and Loan Terms to Negotiate

Loan amount Loan term (maturity) Contract interest rate Amortization rate Up-front fees and points Prepayment option and back-end penalties Recourse vs. Non-recourse debt Collateral (e.g. cross-collateralization) Lender participation in property equity Cramdown insurance Etc.

When Will Leverage Increase Going-in IRR?

Increased leverage will increase the goingin IRR.
when unlevered going-in IRR exceeds the effective borrowing cost

Leverage Bottom Line

In a typical cash flow forecast, increased leverage will increase the going-in IRR However, this increased IRR comes at a price..increased riskiness of the equity investment

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 Detailed physical description
Photos and aerial photos Survey Site plan Structure drawings and specifications

The Loan Submission Package - continued

Market analysis Cash flow pro forma (projections) Appraisal

The Lenders Decision: Loan Underwriting

Qualitative considerations
Property type Location Tenant quality Lease terms Property management Building quality Environmental issues Borrower quality

Loan Underwriting: Crunching the Numbers

Focus on first-year NOI Debt coverage ratio:
DCR = NOIDS: Maximum loan: Max debt service = NOI Required DCR Max debt service = 1,272,5001.25 = $1,018,000

Loan Underwriting: Determining Maximum Loan

Maximum loan continued (monthly pmt)
Monthly debt service: MDS = DS12 = $1,018,00012 = $84,833.33 Assume the lenders terms would be
Term for amortization: 30 years Interest rate: 7.625 360 7.625 $84,833.33 0
n i PV Pmt FV

$11,985,600.86

Loan Underwriting: The Lenders Decision

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 Usually offers option of rate lock.

Underwriting Example
The Problem:
Buyer (borrower) & seller claim property worth $12,222,000; Buyer wants to borrow 75% ($9.167 Million, or $91.67/SF) from you (mortgage lender), for purchase-money 1st mortgage; Wants non-recourse, 10-yr interest-only loan, monthly pmts; Willing to accept lock-out.

Should you do the deal?

Underwriting Criteria
Max Initial LTV = 75%. Current Mortgage Rate 7.87% Max projected terminal LTV = 65%. In computing LTV, normally: (i) Apply direct capitalization with going-in cap rate 9%, terminal cap rate 10%; (ii) Apply multi-yr DCF with Disc. Rate 10%; (iii) Use lower of (i) & (ii) to compute Initial LTV. 5. Min DCR = 120%. 6. Max BER = 85%, or 5% less than market vacancy rate (whichever is less). 7. Consider need for CI, and avoid EBTCF < 0.
1. 2. 3. 4.

Property & RE Market Info (from broker)

100,000SF, fully occupied, single-tenant, off.bldg. 10-yr lease signed 3 yrs ago. $11/SF net (suppose EOY ann. pmts). "Step-ups" of $0.50 in lease yr.5 & 8 (yrs 2 & 5). Current market rents on new 10-yr leases are $12/SF net. Expect market rents to grow @ 3%/yr.

Solution, General Procedure

Step 1: Construct 10-yr Proforma:
1) Forecast Property Cash Flows 2) Calculate Loan Debt Service Cash Flows for Requested Loan

Step 2: Examine DCR, BER, EBTCF, @ Requested Loan:

Is there Compliance with Value Underwriting Criterion?

Step 3: Estimate Property Value (Use Direct Capitalization &/or DCF):

Is there Compliance with Value Underwriting Criterion?

Step 4: If Compliance Fails in either Step 2 or Step 3:

How can loan be modified to meet underwriting criteria?... How much (and why) is lender willing to bend underwriting criteria to make loan?... What yield enhancements (e.g. origination fee) would tempt lender? What security enhancements (e.g. recourse, multi-collateral, cramdown insur) would assuage lender?

Underwriting Example (cont.)

Brokers pro-forma submitted with loan request
Assumes: 75% renewal probability 3 mo. vacancy if non-renewal No provision for CI (inclu leasing expenses) Yr. 10 cap rate = 9%
2 $12.73 $11.50 $0.00 $11.50 $1,150,000 3 $13.11 $11.50 $0.00 $11.50 $1,150,000 4 $13.51 $11.50 $0.00 $11.50 $1,150,000 5 $13.91 $12.00 $0.00 $12.00 $1,200,000 6 $14.33 $12.00 $0.00 $12.00 $1,200,000 7 $14.76 $12.00 $0.00 $12.00 $1,200,000 8 $15.20 $15.20 $0.00 $15.20 $1,520,124 9 $15.66 $15.20 $0.00 $15.20 $1,520,124 10 $16.13 $15.20 $0.00 $15.20 $1,520,124 $16,890,268 Year 11 $16.61 $15.20 $0.00 $15.20 $1,520,124

Year: Mkt Rent (net) /SF Property Rent(net) Vacancy Allow NOI/SF NOI

1 $12.36 $11.00 $0.00 $11.00 $1,100,000

Reversion@9%Cap

So, you need to deal with the usual

You make the following modified assumptions:
1% market rental growth for existing bldg (3%-2% depreciation) Yr. 8 leasing expenses: $2/SF if renew, $5/SF not renew Yr. 8 TI: $10/SF if renew, $20/SF if not renew Yr. 10 cap rate = 10%

Your adjusted pro-forma (based on research):

Assumes: 1% market rental growth for existing bldg (3%-2% depr) Yr. 8 Leasing Expenses: $2/SF if renew, $5/SF not renew Yr. 8 TI: $10/SF if renew, $20/SF if not renew Yr. 10 cap rate = 10%
Year: Mkt Rent (net) /SF Property Rent(net) Vacancy Allow NOI/SF NOI Lease Comm Ten.Imprv Reversion@10%Cap Less OLB PBTCF Debt Svc EBTCF DCR BER @ Mkt $1,100,000 -$721,443 $378,557 152% 60% $1,150,000 -$721,443 $428,557 159% 59% $1,150,000 -$721,443 $428,557 159% 58% $1,150,000 -$721,443 $428,557 159% 58% $1,200,000 -$721,443 $478,557 166% 57% $1,200,000 -$721,443 $478,557 166% 57% $1,200,000 -$721,443 $478,557 166% 56% -$306,786 -$721,443 ($1,028,229) 169% 56% $1,299,428 -$721,443 $577,985 180% 55% 1 $12.12 $11.00 $0.00 $11.00 $1,100,000 $0 $0 2 $12.24 $11.50 $0.00 $11.50 $1,150,000 $0 $0 3 $12.36 $11.50 $0.00 $11.50 $1,150,000 $0 $0 4 $12.49 $11.50 $0.00 $11.50 $1,150,000 $0 $0 5 $12.61 $12.00 $0.00 $12.00 $1,200,000 $0 $0 6 $12.74 $12.00 $0.00 $12.00 $1,200,000 $0 $0 7 $12.87 $12.00 $0.00 $12.00 $1,200,000 $0 $0 8 $12.99 $12.99 $0.81 $12.18 $1,218,214 -$275,000 -$1,250,000 9 $13.12 $12.99 $0.00 $12.99 $1,299,428 $0 $0 10 $13.26 $12.99 $0.00 $12.99 $1,299,428 $0 $0 $12,994,280 $9,167,000 $14,293,709 -$9,888,443 $4,405,266 180% 54% Year 11 $13.39 $12.99 $0.00 $12.99 $1,299,428

Note:

Income underwriting criteria for $9,167,000, 7.87% loan. DCR & BER look good How were these computed?

Year: Mkt Rent (net) /SF Property Rent(net) Vacancy Allow NOI/SF NOI Lease Comm Ten.Imprv Reversion@10%Cap Less OLB PBTCF Debt Svc EBTCF DCR BER @ Mkt

1 $12.12 $11.00 $0.00 $11.00 $1,100,000 $0 $0

2 $12.24 $11.50 $0.00 $11.50 $1,150,000 $0 $0

3 $12.36 $11.50 $0.00 $11.50 $1,150,000 $0 $0

4 $12.49 $11.50 $0.00 $11.50 $1,150,000 $0 $0

5 $12.61 $12.00 $0.00 $12.00 $1,200,000 $0 $0

6 $12.74 $12.00 $0.00 $12.00 $1,200,000 $0 $0

7 $12.87 $12.00 $0.00 $12.00 $1,200,000 $0 $0

8 $12.99 $12.99 $0.81 $12.18 $1,218,214 -$275,000 -$1,250,000

9 $13.12 $12.99 $0.00 $12.99 $1,299,428 $0 $0

10 $13.26 $12.99 $0.00 $12.99 $1,299,428 $0 $0 $12,994,280 $9,167,000

Year 11 $13.39 $12.99 $0.00 $12.99 $1,299,428

$1,100,000 -$721,443 $378,557 152% 60%

$1,150,000 -$721,443 $428,557 159% 59%

$1,150,000 -$721,443 $428,557 159% 58%

$1,150,000 -$721,443 $428,557 159% 58%

$1,200,000 -$721,443 $478,557 166% 57%

$1,200,000 -$721,443 $478,557 166% 57%

$1,200,000 -$721,443 $478,557 166% 56%

-$306,786 -$721,443 ($1,028,229) 169% 56%

$1,299,428 -$721,443 $577,985 180% 55%

$14,293,709 -$9,888,443 $4,405,266 180% 54%

DCR (Yr.1) = NOI / DS = $1,100,000 / $721,443 = 1.52

BER (Yr.1) = (OE + DS) / PGI = ($0 + $7.214) / $12.12 = 0.59
DS from: $9,167,000 X 7.87% = $721,443, in Interest-Only Loan.

Although standard income ratios look good, this loan does have some problems.

Year: Mkt Rent (net) /SF Property Rent(net) Vacancy Allow NOI/SF NOI Lease Comm Ten.Imprv Reversion@10%Cap Less OLB PBTCF Debt Svc EBTCF DCR BER @ Mkt

1 $12.12 $11.00 $0.00 $11.00 $1,100,000 $0 $0

2 $12.24 $11.50 $0.00 $11.50 $1,150,000 $0 $0

3 $12.36 $11.50 $0.00 $11.50 $1,150,000 $0 $0

4 $12.49 $11.50 $0.00 $11.50 $1,150,000 $0 $0

5 $12.61 $12.00 $0.00 $12.00 $1,200,000 $0 $0

6 $12.74 $12.00 $0.00 $12.00 $1,200,000 $0 $0

7 $12.87 $12.00 $0.00 $12.00 $1,200,000 $0 $0

8 $12.99 $12.99 $0.81 $12.18 $1,218,214 -$275,000 -$1,250,000

9 $13.12 $12.99 $0.00 $12.99 $1,299,428 $0 $0

10 $13.26 $12.99 $0.00 $12.99 $1,299,428 $0 $0 $12,994,280 $9,167,000

Year 11 $13.39 $12.99 $0.00 $12.99 $1,299,428

$1,100,000 -$721,443 $378,557 152% 60%

$1,150,000 -$721,443 $428,557 159% 59%

$1,150,000 -$721,443 $428,557 159% 58%

$1,150,000 -$721,443 $428,557 159% 58%

$1,200,000 -$721,443 $478,557 166% 57%

$1,200,000 -$721,443 $478,557 166% 57%

$1,200,000 -$721,443 $478,557 166% 56%

-$306,786 -$721,443 ($1,028,229) 169% 56%

$1,299,428 -$721,443 $577,985 180% 55%

$14,293,709 -$9,888,443 $4,405,266 180% 54%

Another problem is in the initial LTV: Based on direct capitalization, loan passes OK:
$1,100,000 / 9% = $12.22 M, LTV = 9.167 / 12.22 = 75%.

Negative EBTCF in Yr. 8

But the DCF @ 10% gives PV(PBTCF) = $11,557,000.

9.167 / 11.557 = 79%.

A similar problem is in the Terminal LTV:

$9,167,000 / $12,994,280 = 71%, which is > the 65% limit.

Problems in the Loan Proposal

Income: Projected EBTCF (Yr. 8) = -$1,028,229 < 0 Value: Initial LTV Ratio = 79% > 75% (in DEF @ 10%, OK in dir cap) Terminal LTV Ratio = 71% > 65% (@ 10% cap rate) But EBTCF < 0 is: Due mostly to cap impr (financing possible?) Far in future (when inflation will have improved default risk) After much previous positive cash flow Not untypical in single tenant bldg. And Value criteria are missed only slightly. So, loan is close to passing criteria. How good a future potential customer is this borrower? How much pressure is there in the loan market? Try to negotiate a similar loan?...

Consider
A $8,700,000 loan with 40-yr amortization 10-yr balloon (instead of $9,167,000, interest only):
$9,167,000 Int-Only PMT Initial OLB Initial LTV Ratio $721,443 $9,167,000 79% $8,700,000 40-yr Amort $715,740 $8,700,000 75%

Terminal OLB
Terminal LTV Ratio

$9,167,000
71%

$8,230,047
63%