Transcript Stone Arch Village - University of Illinois at Urbana

Fundamentals of Real Estate
Lecture 15
Spring, 2003
Copyright © Joseph A. Petry
www.cba.uiuc.edu/jpetry/Fin_264_sp03
Housekeeping
Course Coverage and progression
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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 $1.3trn 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.
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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.
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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.
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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.
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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:
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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.
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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
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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.
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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.
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Lock-out provisions prohibit prepayment for a particular period
after origination.
They serve to reduce lenders’ reinvestment risk
Commercial Property Financing:
Chapter 17
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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:
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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
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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.
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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.
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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:
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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
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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
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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
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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:
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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.
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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
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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
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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
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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
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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
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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.
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Commercial Property Financing:
Chapter 17
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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.