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This lecture handout is from Real Estate Investment Analysis course. Keywords in this lecture are: Commercial Mortgage Finance, Diversification, Benefits of Leverage, Benefits and Costs of Leverage, Amplifying the Gain on Disposal, Cons of Leverage, Long-Term Commercial Mortgages, Mortgage Loan Conduits, Loan-To-Value, Underwriting Guidelines
Typology: Exercises
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Commercial Mortgage Finance
Most real estate purchases involve substantial amounts of leverage.
a) Benefits of leverage:
Diversification
Suppose you have $1,000,000 to invest.
How many properties can you purchase if you only use cash?
If you borrow 80 percent of the purchase price, how much property can you purchase?
“Working the spread”
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Amplifying the gain on disposal
Using the example above, suppose each of the properties increased in value by 5% per year for 5 years. Then at the end, your investment in a single property would be worth __________, for a __________ gain on the investment.
But if you borrowed 80% of the purchase price, your total property would have increased to $6.381 million. Minus the $ million you borrowed, this increases your total cash flow to __________ or a __________ capital gain.
Note: this is really rough, and ignores early principal repayment. Nevertheless, the idea is clear.
b) Cons of Leverage
Leverage increases risk, both for annual cash flows and for any capital gains at the end of the holding period.
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Why would prepayment penalties be more prevalent with commercial loans than they are with residential mortgages?
How might a prepayment penalty actually benefit a borrower?
c) Commercial mortgages are more likely to be funded by:
Insurance companies, pension funds, and other institutional investors
Mortgage loan conduits (to other parties or secondary market investors)
Commercial banks are still a common source of financing for commercial real estate projects because of their _______________.
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d) Underwriting Guidelines
Note: Specific guidelines for a lender may vary by property type and use.
Loan-to-value (LTV) ratios
Recourse vs. non-recourse
A recourse loan is one in which the borrower or some other party is personally responsible for repayment of the loan.
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Property characteristics
Size
Location
Age
Quality
Other collateral
Portfolio mix
Lease analysis
Tenant creditworthiness
Remember, a lease is a debt agreement, so the lender must underwrite the tenant as well. If the tenant goes bankrupt, it is possible that the property may come back to the lender.
Lease Characteristics
Tenant mix
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a) Recall that before we introduced the concept of a mortgage constant:
The mortgage constant (MC) is the annual payment per dollar borrowed.
Consider again the example above (a $900,000 property with $89, in annual NOI financed over 20 years at 9 percent interest with a 75 percent LTV mortgage).
The cap rate on that property is __________.
What is the mortgage constant on this loan?
Question: Why doesn’t it matter whether we calculate this using the larger or smaller loan amount (recall that the DCR limited the size of the loan the lender was willing to provide)?
The MC represents the total cost of the loan, including both the interest and the principal portions of the loan.
