Fundamentals of Real Estate Lecture 15 Spring 2003

Fundamentals of Real Estate Lecture 15 Spring, 2003 Copyright © Joseph A. Petry www. cba. uiuc. edu/jpetry/Fin_264_sp 03

Housekeeping Course Coverage and progression l l l 2 We will not cover “Valuation of Leased Fee Estates” in Chapter 13 (pp 334 -336). You are responsible for the remainder of Chapter 13, which includes calculating cap rates via direct market extraction and simple mortgage equity analysis, as well as calculating the equity dividend rates from market data. Other topics briefly touched on include the Gross Income Multiplier and final reconciliation. We will be rearranging the chapter order in the next section of the book: Mortgage Finance Perspective. We will begin today with Chapter 17, Commercial Property Financing, and then do Chapter 14 on Monday.

Commercial Property Financing: Chapter 17 Sources of Financing for Commercial Properties As of 1999, approximately $1. 3 trn of mortgage debt was allocated to commercial projects, including apartment buildings The primary commercial mortgage market is dominated by commercial banks and life insurance companies. l l 3 Commercial banks hold 39% of the total long-term commercial real estate debt outstanding Life insurance companies hold 13% fo the total long-term commercial real estate debt outstanding

Commercial Property Financing: Chapter 17 In recent years the size of the CMBSs market has grown dramatically. l l CMBSs are backed by a pool of commercial mortgages or, perhaps, a single large commercial loan. The value of commercial mortgages used as collateral for CMBSs was 17% of outstanding commercial mortgages. The construction loan market is also dominated by commercial banks. l 4 In 1997, commercial banks held 79% of the outstanding construction loans, followed by mortgage bankers (11%) and savings institutions (6%).

Commercial Property Financing: Chapter 17 Loan Documents and Provisions Generally, fewer rules and other constraints govern loan terms and lender-borrower relationships for commercial property financing than for single-family residential lending. Commercial mortgages are typically 5 - or 10 -year mortgages and often include a balloon payment. Commercial mortgages are often nonrecourse, rather than recourse loans. 5

Commercial Property Financing: Chapter 17 A. The Note As in residential mortgages, the note is the document used to create a debt when a loan is made in real estate. In commercial property financing, the note is lengthy, and includes provisions such as: – – – – 6 amount and timing of periodic payments, the calculation of payments record keeping calculation of the property’s income property maintenance default procedures, and penalties

Commercial Property Financing: Chapter 17 Many commercial properties are financed with a note, because the note creates personal liability for the borrowers. – – recourse loans are those loans for which the borrower is personally liable (financing contains a note) nonrecourse loans are those loans for which the borrower is not personally liable (financing does not contain a note) B. The Mortgage As in a residential mortgage, the income property mortgage creates the security for the lender. Common types of Permanent Mortgages – 7 – – fully-amortizing mortgages partially-amortizing mortgages, and interest-only loans

Commercial Property Financing: Chapter 17 A. Balloon Mortgages The most common instrument of financing commercial property. – – Payments are typically based on a 25 -year or 30 -year amortization schedule, but the loan matures in 5, 7 or 10 years. The relatively short term reduces the lender’s inflation and interest rate risk. B. Common Loan Provisions Most commercial loans do not allow borrowers to freely prepay the loan. Most contain either prepayment penalties or lock-ou provisions. – 8 – Lock-out provisions prohibit prepayment for a particular period after origination. They serve to reduce lenders’ reinvestment risk

Commercial Property Financing: Chapter 17 – Yield maintenance provisions represent a specific type of prepayment penalty. The penalty is set depending on how far interest rates have declined since origination. C. Floating-Rate Loans Commercial mortgages often have floating, or adjustable, interest rates. These rates are often set relative to some cost of funds index (e. g. the prime rate). D. Installment Sale Financing The installment sale is a popular method used to defer taxes due on the sale of commercial property. Under this “financing” method: – 9 – the purchase price is paid over a period of years, the buyer makes periodic payments to the seller consisting of principal and interest

Commercial Property Financing: Chapter 17 – the taxable gain is recognized (deferred) in future years as principal is received. In effect, the seller lends the buyer funds as the property is purchased over the installment period. Permanent Mortgages with Equity Participation A. Participation Mortgages Commercial mortgage loans may be structured to give the lender an “equity-like” interest in the property by participating in the property’s operating cash flows and/or participating in the cash flows from the eventual sale of the property, or both. 10

Commercial Property Financing: Chapter 17 In exchange for a share of the property’s income or appreciation, the lender must offer the borrower a below market interest rate. l l l 11 Income kickers require borrowers to pay the lender a specified percentage of the property’s gross, or net, income. Equity kickers require borrowers to pay the lender a percentage of the proceeds from the sale of the property. Contingent interest is the additional payments received by the lender contingent on the performance of the property in the participation. B. Joint Ventures Produces a relationship similar to a participation in that

Commercial Property Financing: Chapter 17 the lender expects to receive a portion of the cash flows from the operation and sale of the property. In a joint venture the lender actually acquires an ownership interest in the property. The lenders total return comes from: l l 12 the return on the debt position the return on the equity position C. Sale-Leasebacks Lenders may take a complete equity position in a property by purchasing the property and leasing it back to the tenant.

Commercial Property Financing: Chapter 17 The tenant may want to invest its funds in its business assets, and not in the property. The owner (in this case a lender) may find tax advantage or long-term investment advantages to such an arrangement. The Borrower’s Decision-Making Process 13 Investors deciding to purchase a commercial building must decide whether to finance the project using a balloon mortgage, a floating rate mortgage, or some other more complicated arrangement (participation loans, joint ventures, etc. )

Commercial Property Financing: Chapter 17 14 A. Loan size Real estate investors use borrowed funds: – to increase the size of their purchase (affordability) – to magnify their expected rate of return (leverage) Positive leverage occurs when the after-tax cost of borrowing is less than the after-tax unleveraged return Negative leverage occurs when the after-tax cost of borrowing is greater than the after-tax unleveraged return Leverage increases risk of default and return variability

Commercial Property Financing: Chapter 17 15 B. Financial Risk Financial risk is defined as the ability to meet debt obligations--the risk that the property’s NOI will be insufficient to cover the mortgage obligations. Default risk is the risk that the borrowers will cease to make timely payments of principal and interest. C. Increased Variability of Equity Returns from Leverage The expected variability of the returns to equity investors, increases with the amount of financial leverage. Leverage serves to magnify returns from both operations and sale of the asset.

Commercial Property Financing: Chapter 17 D. Choosing among Alternative Financing Structures When comparing commercial mortgage structures, it is important to be aware of how borrowers and lenders evaluate the trade-offs between the various loan types and contract provisions. A “win-win” can be created if the borrower and lender place different values on the cash flows that are sacrificed or gained. To aid in the mortgage selection process, borrowers and lenders should: l 16 consider borrowing cost and IRR on equity of various options as well as the relative risk of alternative financing

Commercial Property Financing: Chapter 17 E. Prepayment and Default Decisions As with residential mortgages, the most accurate guide to a commercial mortgage refinancing decision is to evaluate the NPV of the expected cash flows. Evidence indicates that commercial borrowers do not immediately default on their loans when the value of their property drops below the remaining balance on the mortgage. There are costs associated with default, and many borrowers may expect their property’s value to increase. 17

Commercial Property Financing: Chapter 17 Requesting a Permanent Loan There are three basic steps in obtaining debt financing for commercial property (loan underwriting process): 1) the prospective borrower submits loan package 2) the lender analyzes the loan application 3) if application is accepted, the loan is closed. A. Loan Submission Package 18 1. Loan application specifies amount requested, loan terms, and identity of the borrower. It includes borrowers financial statements, a credit report, a projection of how the loan is to be repaid, and the borrower’s experience.

Commercial Property Financing: Chapter 17 2. Property description includes surveys, plot plans and topographical maps. 3. Legal aspects including legal description of the property, easements, encroachments, as well as property taxes, special assessments, zoning, deed restrictions and environmental requirements. 4. Cash flow estimates from operations using DCF analysis. 5. Appraisal report from third party. 6. Feasibility study for larger projects--is the project financially feasible, and does the target market exist. B. Channels of Submission 19 Can be submitted directly to lender or indirectly via a mortgage broker or banker

Commercial Property Financing: Chapter 17 A relationship in which a lender agrees to purchase loans or to consider loan requests from a mortgage banker is termed a correspondent relationship. The Lender’s Decision-Making Process A. The property and borrowers – – – 20 – property type and quality property location quality of the tenants and terms of each lease any environmental concerns experience of the borrower property management borrower’s resources

Commercial Property Financing: Chapter 17 B. The maximum loan amount – – Loan-to-Value ratio (LTV) LTV = Value of the mortgage / Value of the property Debt service coverage ratio (DCR) DCR = Net Operating Income / Debt Service Maximum Debt Service = NOI / Lenders minimum DCR Acquisition, Development, and Construction Financing A. Land Purchase and Development Financing 21 Land acquisition loans finance the purchase of raw land Land development loans finance the installment of on- and offsite improvements such as sewers, streets, and utilities.

Commercial Property Financing: Chapter 17 Developers may secure land for future developments with a land purchase option. The purchase of such an option from the landowner gives the developer the right, but not the obligation, to purchase the land before the expiration date of the option at a predetermined price. Construction loans are used to finance the costs of erecting the building improvements. B. Construction Financing Construction loans are short term arrangements that cover the length of the construction period. The interest rate is generally a floating rate set at 2 to 5 percent above the prime lending rate. In most cases, the interest payments are deferred and added to the outstanding construction loan balance and paid off with the proceeds of the sale. 22

Commercial Property Financing: Chapter 17 23 Construction loans are received as a series of “draws”, after the completion of the specified stages of the building. 1. Take-out commitments An agreement by a permanent lender to provide permanent financing for the project when a certain event occurs, normally the completion of the project (or a certain percentage of the project preleased). The construction lender often requires a standby or take-out commitment. 2. Open-ended loans An open-ended loan is financing for the construction period without a take-out commitment from a permanent lender. 3. Mini-perm loans A single short-term permanent mortgage from an interim lender for construction, lease-up and a few years after.