Comme Rical Mortgage and Underwriting

7/30/2019 Comme Rical Mortgage and Underwriting

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Commercial Mortgages:Market, Types and

Underwriting Decisions


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Typology of mortgages, Overviewof the mortgage industry

Mortgages

Residential Commercial

GovtInsured

Conventional Permanent Constructionand

Development


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Construction and DevelopmentFinancing

Land acquisition financing

Land development loan

Construction loan

Mini-perm loan


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The classical construction finance structure:

Phase:

Financing:

Construction Lease-Up Stabilized

Operation

C.O.

Construction Loan Bridge Loan Permanent Mortgage

Source:

Commercial

Bank

Comm. Bank

Insur Co.

Via Mortg Brkror Mortg

Banker: Life Insur. Co.

Pension Fund

ConduitCMBS

Construction lender wont approve

construction loan until permanent lenderhas conditionally approved a take-outloan.


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Sources of CommercialMortgage Financing

Commercial banks

Life insurance companies

Pension funds

Conduit lenders

Correspondent lenders


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The Capital Stack

Equity } 5%Preferred Equity } 5%

Sub. Mezzanine Loan }10%

Sen. Mezzanine Loan }10%

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

Senior Debt }50%

Equity } 35%

First Mortgage } 65%

Traditional and

Modern

Modern

(before 2008)


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Commercial Loansvs. Residential Loans

Commercial mortgages and notes are notstandardized.

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.


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Default and Foreclosure

Default is a violation of a clause orcovenant in the mortgage or noteagreement

Litigious settlementSue for specific performance

Sue for damages

Sue for foreclosure

Nonlitigous settlement

Exercise forbearance (workout, deed in lieu offoreclosure, restructuring (partners and/or terms))


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Costs of Foreclosure

Legal and administrative (can be 10% ormore of loan)

Deterioration of property value

Reputation effects

Regulatory effects (write-down)

Lost revenue (interest during the process)


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Priority of Claims in Foreclosure

Lien Priority established by Date ofRecording, 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


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Redeem up, Foreclose down

Senior Lien Holders obtain their claim (to theextent foreclosure sale proceeds and theirpriority allows), even if they did not bring the

suit.Junior Lien Holders lose claims afterforeclosure, providedthey are included in theforeclosure suit.

Lien Holder brining foreclosure suit normallybuys the property in the foreclosure sale, foramount sufficient to cover its claim.


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Permanent CommercialMortgage Market

The primary market is dominated bycommercial banks and life insurancecompanies.

In recent years, the size of the CMBS markethas grown dramatically. This is the secondarymarket.

Commercial mortgages are typically 5- to 10-years, and often include a balloon payment.

Permanent commercial mortgages are often

nonrecourse loans.


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Permanent CommercialMortgage Market

Correspondent lender

Mortgage banker

Mortgage broker Presents loan package to:

Life insurance companies

Pension funds

TrustsLarge banks

Credit companies (GE Capital, Ford, other)

Receives fee of - 1% of loan


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With much of the debt beingsecuritized

Commercial

Real Estate

Asset

Equity

Debt

Equity

Unrated

B

BB

BBB

A

AA

AAA

Payments

LoansCommercial Mortgage

Securitization

Non-In

vestment

GradeSecurities

Investment

GradeSecurities


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TrusteeOversees Pool

Servicer(Master Svcr,

Sub-Svcrs)

Collects CF

Special SevicerDeals with

defaults, workouts


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CMBS Securitization


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Mortgage Yield: The Components of ExAnte Returns

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

Real rf

Infla

Yld Crv

Default Risk

Yld Degr

Illi

Total Yield

Pure time-value-of-money component of required

return. Varies w Fed policy & supply/demand for short

term capital.

If inflation rate expected in short run,.

Yield curve (premium of LT over ST T-Bonds), reflects

interest rate risk, liquidity preference (habitat), mkt

expectations about fut. int.rates

Due to riskof default (not expectation of default):

Due to expectation of default (not risk of default)

Due to illiquidity in individual bonds, mortgages.


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Other Forms of CommercialMortgage 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.


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Joint Venture - continued

Usually between a developer of a largeproject and:

Pension fund.

Life Insurance company.

REIT

Institution provides the construction

financing and/or long-term financing, inaddition to some of required equity capital

Shares and claims to operating and sale

cash flows are negotiated


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Other Forms of CommercialMortgage Financing - continuedSale-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.


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Sale-Leaseback - continued

User benefits:

Lease payment is deductible for incometaxes.

Equity capital remains available for corebusiness.

Investor benefits:

Can be extremely safe investment. Inflation hedged (especially if lease payments

increase with inflation).


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Other Forms of CommercialMortgage 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.


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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.


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FHA insured loans for low and moderateincome multifamily housing.

Freddie Mac and Fannie Mae multifamilylending programs

Many targeted to low and moderate income

housing.


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Important Underwriting Ratios

Debt coverage ratio: indicator of the cash

flow cushion.

DCR = NOIDSNOI 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


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Important Underwriting Ratios

Break-even Ratio

BER = (OE + CAPX + DS)PGI

Gives Required occupancy level (approx.)

V i bl d L T t


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Variables and Loan Terms toNegotiate

Loan amount

Loan term (maturity)

Contract interest rate

Amortization rateUp-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.


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When Will Leverage IncreaseGoing-in IRR?

Increased leverage will increase the going-in IRR.

when unlevered going-in IRR exceeds theeffective borrowing cost


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Leverage Bottom Line

In a typical cash flow forecast, increasedleverage will increase the going-in IRR

However, this increased IRR comes at aprice..increased riskiness of the equityinvestment


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Obtaining a CommercialMortgage 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


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The Loan Submission Package- continued

Market analysis

Cash flow pro forma (projections)

Appraisal


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The Lenders Decision:

Loan UnderwritingQualitative considerations

Property type

Location

Tenant quality

Lease terms

Property management

Building quality

Environmental issues

Borrower quality


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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


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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

PV Pmtin FV

360 7.625 $84,833.33 0

$11,985,600.86


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Loan Underwriting:The Lenders Decision

Due-diligence: review and verification ofthe facts and analysis in the loan

submission package. Verify facts (check for credibility andconsistency).

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.


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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), forpurchase-money 1st mortgage;

Wants non-recourse, 10-yr interest-only loan,

monthly pmts;

Willing to accept lock-out.

Should you do the deal?


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Underwriting Criteria

1. Max Initial LTV = 75%.2. Current Mortgage Rate 7.87%3. Max projected terminal LTV = 65%.4. In computing LTV, normally: (i) Apply direct

capitalization with going-in cap rate 9%,terminal cap rate 10%; (ii) Apply multi-yr DCFwith 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.


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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.


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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?


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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%

Year: 1 2 3 4 5 6 7 8 9 10 Year 11

Mkt Rent (net) /SF $12.36 $12.73 $13.11 $13.51 $13.91 $14.33 $14.76 $15.20 $15.66 $16.13 $16.61

Property Rent(net) $11.00 $11.50 $11.50 $11.50 $12.00 $12.00 $12.00 $15.20 $15.20 $15.20 $15.20Vacancy Allow $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00

NOI/SF $11.00 $11.50 $11.50 $11.50 $12.00 $12.00 $12.00 $15.20 $15.20 $15.20 $15.20

NOI $1,100,000 $1,150,000 $1,150,000 $1,150,000 $1,200,000 $1,200,000 $1,200,000 $1,520,124 $1,520,124 $1,520,124 $1,520,124

Reversion@9%Cap $16,890,268

S d t d l


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So, you need to dealwith the usual

You make the following modifiedassumptions:

1% market rental growth forexistingbldg (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


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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 renewYr. 8 TI: $10/SF if renew, $20/SF if not renew

Yr. 10 cap rate = 10%Year: 1 2 3 4 5 6 7 8 9 10 Year 11

Mkt Rent (net) /SF $12.12 $12.24 $12.36 $12.49 $12.61 $12.74 $12.87 $12.99 $13.12 $13.26 $13.39

Property Rent(net) $11.00 $11.50 $11.50 $11.50 $12.00 $12.00 $12.00 $12.99 $12.99 $12.99 $12.99

Vacancy Allow $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.81 $0.00 $0.00 $0.00

NOI/SF $11.00 $11.50 $11.50 $11.50 $12.00 $12.00 $12.00 $12.18 $12.99 $12.99 $12.99

NOI $1,100,000 $1,150,000 $1,150,000 $1,150,000 $1,200,000 $1,200,000 $1,200,000 $1,218,214 $1,299,428 $1,299,428 $1,299,428

Lease Comm $0 $0 $0 $0 $0 $0 $0 -$275,000 $0 $0

Ten.Imprv $0 $0 $0 $0 $0 $0 $0 -$1,250,000 $0 $0


Less OLB $9,167,000

PBTCF $1,100,000 $1,150,000 $1,150,000 $1,150,000 $1,200,000 $1,200,000 $1,200,000 -$306,786 $1,299,428 $14,293,709

Debt Svc -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$9,888,443

EBTCF $378,557 $428,557 $428,557 $428,557 $478,557 $478,557 $478,557 ($1,028,229) $577,985 $4,405,266

DCR 152% 159% 159% 159% 166% 166% 166% 169% 180% 180%

BER @ Mkt 60% 59% 58% 58% 57% 57% 56% 56% 55% 54%

Note: Income underwriting criteria for $9,167,000, 7.87% loan.

DCR & BER look good

How were these computed?

Year: 1 2 3 4 5 6 7 8 9 10 Year 11


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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.

Mkt Rent (net) /SF $12.12 $12.24 $12.36 $12.49 $12.61 $12.74 $12.87 $12.99 $13.12 $13.26 $13.39


Vacancy Allow $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.81 $0.00 $0.00 $0.00

NOI/SF $11.00 $11.50 $11.50 $11.50 $12.00 $12.00 $12.00 $12.18 $12.99 $12.99 $12.99

NOI $1,100,000 $1,150,000 $1,150,000 $1,150,000 $1,200,000 $1,200,000 $1,200,000 $1,218,214 $1,299,428 $1,299,428 $1,299,428

Lease Comm $0 $0 $0 $0 $0 $0 $0 -$275,000 $0 $0

Ten.Imprv $0 $0 $0 $0 $0 $0 $0 -$1,250,000 $0 $0


Less OLB $9,167,000

PBTCF $1,100,000 $1,150,000 $1,150,000 $1,150,000 $1,200,000 $1,200,000 $1,200,000 -$306,786 $1,299,428 $14,293,709

Debt Svc -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$9,888,443

EBTCF $378,557 $428,557 $428,557 $428,557 $478,557 $478,557 $478,557 ( $1,028,229) $577,985 $4,405,266

DCR 152% 159% 159% 159% 166% 166% 166% 169% 180% 180%

BER @ Mkt 60% 59% 58% 58% 57% 57% 56% 56% 55% 54%

Year: 1 2 3 4 5 6 7 8 9 10 Year 11

Mkt Rent (net) /SF $12 12 $12 24 $12 36 $12 49 $12 61 $12 74 $12 87 $12 99 $13 12 $13 26 $13 39


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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%.

But the DCF @ 10% gives PV(PBTCF) = $11,557,000.9.167 / 11.557 = 79%.

Mkt Rent (net) /SF $12.12 $12.24 $12.36 $12.49 $12.61 $12.74 $12.87 $12.99 $13.12 $13.26 $13.39


Vacancy Allow $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.81 $0.00 $0.00 $0.00

NOI/SF $11.00 $11.50 $11.50 $11.50 $12.00 $12.00 $12.00 $12.18 $12.99 $12.99 $12.99

NOI $1,100,000 $1,150,000 $1,150,000 $1,150,000 $1,200,000 $1,200,000 $1,200,000 $1,218,214 $1,299,428 $1,299,428 $1,299,428

Lease Comm $0 $0 $0 $0 $0 $0 $0 -$275,000 $0 $0

Ten.Imprv $0 $0 $0 $0 $0 $0 $0 -$1,250,000 $0 $0

Reversion@10%Cap $12,994,280Less OLB $9,167,000

PBTCF $1,100,000 $1,150,000 $1,150,000 $1,150,000 $1,200,000 $1,200,000 $1,200,000 -$306,786 $1,299,428 $14,293,709

Debt Svc -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$721,443 -$9,888,443

EBTCF $378,557 $428,557 $428,557 $428,557 $478,557 $478,557 $478,557 ($1,028,229) $577,985 $4,405,266

DCR 152% 159% 159% 159% 166% 166% 166% 169% 180% 180%

BER @ Mkt 60% 59% 58% 58% 57% 57% 56% 56% 55% 54%

A similar problem is in the Terminal LTV:

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

NegativeEBTCF in Yr. 8


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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?...


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Consider

A $8,700,000 loan with 40-yr amortization10-yr balloon (instead of $9,167,000,interest only):

$9,167,000 Int-Only $8,700,000 40-yr Amort

PMT $721,443 $715,740

Initial OLB $9,167,000 $8,700,000

Initial LTV Ratio 79% 75%

Terminal OLB $9,167,000 $8,230,047

Terminal LTV Ratio 71% 63%