This chapter emphasizes the different perspectives of lenders and borrowers and how that dynamic plays into the negotiated terms of a loan. Lenders must focus on limiting their downside given their limited upside, while borrowers seek to minimize borrowing costs, restriction covenants, and associated liabilities. The chapter addresses loan interest variations, loan sizing approaches, covenants, and the refinancing decision and its risks.
The loan interest rate charged to borrowers is either fixed or floating (variable), with the latter type involving a periodic resetting of the rate based on either the current LIBOR or rates associated with shorter-term U.S. Treasuries. The term of debt is the amount of time over which principal can remain outstanding. Short-term debt is generally 3-5 years in length, and long-term debt is generally 10-30 years. Monthly interest can be calculated using a number of methodologies, with 30/360 being the most prevalent historically.
Lenders will generally underwrite a loan based on several financial ratios, including:
Loan-to-Value (LTV) – The principal amount of the loan divided by the collateral value. The ratio reflects the equity cushion the lender believes they have above the value of the loan. Typical LTVs for secured first mortgages range from 50%-70%.
Loan-to-Cost (LTC) – This ratio applies in the context of construction loans, which are based on budgeted project costs, not the value of an existing operating asset. Typical construction loan LTCs are in the range of 60%-70%.
Debt Yield – Also expressed as a percentage, this ratio is the first year’s NOI divided by the loan amount. Targeted debt yields run from 8%-13%.
Interest Coverage Ratio – The property NOI divided by the annual interest payment. The ratio indicates how many times NOI can cover the interest obligation and gives the lender an idea of how much income cushion the borrower has in terms of their ability to pay interest on the loan. Typical interest coverage ratios are 1.2x to 2.0x for secured first mortgages.
Debt Service Coverage Ratio – The property NOI divided by the annual debt service payment. This differs from the interest coverage ratio by including amortization of the loan (principal payment). Debt service coverage ratios generally exceed 1.2x for secured first mortgages.
Fixed Charges Ratio – The property NOI divided by all fixed charges incurred annually. Fixed charges include all debt service (including unsecured debt payments), ground lease payments, and operating lease payments.
While these ratios are all important, loan covenants are often far more important and contentiously negotiated. Covenants are the terms or clauses of the loan agreement. In short, positive covenants are things you must do and negative covenants are things you cannot do, as they relate to the mortgage loan.
Common negative covenants include:
Prepayment Penalty – If the borrower pays off the loan prior to maturity, they must generally pay a predetermined penalty. The penalty is generally meant to ensure that the lender is “made whole” based on the originally agreed upon terms of the loan.
Dividends – Lenders may restrict the distributions paid to equity holders. Requiring a certain reserve amount provides a cushion for lenders during hard times.
Operating Restrictions – Lenders may make a borrower agree to a loan acceleration if certain operating performance metrics, such as minimum occupancy, are not met.
Additional Debt – Lenders may not allow you to obtain additional financing without their permission.
Common positive covenants include:
Deposits – Lenders might require you to maintain a minimum deposit balance with them.
EBIT, Cash Flow, or NOI – Lenders may require that the property maintain minimum levels of EBIT, Cash Flow, or NOI.
Leases – Lenders may require that the borrower provides copies of all new leases prior to execution.
The following is a list of critical loan terms:
Secured – Secured lenders are secured in their payment positions by recourse to the assets of the property.
Recourse – Non-recourse loans are loans that are solely secured by the property’s assets. Alternatively, lenders may additionally secure the loan against the personal assets of the borrower. This would then be considered a personal recourse loan. Most first mortgages are non-recourse, except for specially carved out “bad boy” acts by the borrower (fraud) and completion guarantees for development.
Receivables – In addition to the leases, the lender may have rights to outstanding lease payments, meaning that any monies owed by tenants to the landlord accrue to the lender in order to satisfy loan losses.
Draws – For construction loans, you must present the lender with supporting documentation on the use of loan proceeds.
Amortization Schedule – Instead of simply paying interest, most loans also have a specific amortization schedule.
Insurance –A common loan covenant is that the borrower must maintain all insurance on the property that is “customary and typical,” in an amount equal to at least the loan balance.
Sweep – Any money that comes into the property must generally be paid to the lender until contractual loan obligations are satisfied.
Loan Points – The fee that a lender will charge for processing the loan. Typically, 30 to 100 basis points of the total loan amount are due up front.
Deciding whether to refinance early is a very difficult decision. Property owners tend to refinance to:
1) take tax-free dollars out of a property that has appreciated in value;
2) enjoy significantly lower interest rates. The most common problems associated with premature refinancing are: the time and energy involved; fees; more stringent loan terms; and prepayment penalties.
Four cases illustrate when a refinancing makes sense despite prepayment penalties:
1) you refinance with the same lender and convince them to waive or reduce the prepayment penalties;
2) you believe that interest rates are at unsustainably low levels;
3) you decide to take money off the table;
4) you can borrow at notably lower rates due to a superior credit rating or access to cheap capital.
These are the types of questions you’ll be able to answer after studying the full chapter.
1. What five key ratios that lenders consider? How do they differ? What is the most conservative ratio for a lender to apply?
2. What are some typical negative loan covenants?
3. Why would borrowers want to refinance?
4. What are the largest impediments to refinancing?
Mezzanine financing and inter-creditor agreements (7:12)
Loan guarantees and “bad boy” carve-outs (6:10)
Re-financing as a business strategy (4:56)
To view the definition, click or press on the term. Repeat to hide the definition.
A nominal rate that stays constant for the duration of the loan term.
Adjusts with the debt markets; the rate the borrower pays is reset at a negotiated time interval.
A ceiling on how high a variable interest rate can rise.
The amount of time over which loan principal can remain outstanding.
The most prevalent loan interest calculation method, which takes the nominal interest rate and divides it by 360 days to get the daily equivalent rate, then multiples this daily rate by 30 to get the monthly rate.
A loan interest calculation basis in which the monthly rate is calculated by taking the annual interest rate, dividing it by 365 days and then multiplying that daily rate by the number of days in the current month.
A loan interest calculation method in which the annual rate is divided by 360 days (not 365) and then multiplied by either 365 or 366; this is the most expensive basis of calculation for the borrower.
The analytical process that a lender uses to assess the risk of a potential loan.
The principal amount of the loan divided by the estimated property value; the LTV % reflects how much equity cushion the lender believes they have before the loan is “underwater” (the property value falls below the outstanding loan amount).
A valuation method for properties based on comparable sales or income capitalization.
The amount of construction loan principal as a percentage of total eligible development costs.
With respect to a construction loan, these are the costs for property development elements that have collateral value to the lender, and, thus, liquidation value in the event of a foreclosure. Eligible loan costs include land, hard costs and non-financing-related soft costs.
A loan sizing ratio that is calculated as the first year’s NOI divided by the loan amount. The debt yield can be thought of as the “lender’s cap rate.”
A loan-sizing ratio that divides the property NOI by the annual interest payment. Indicates how many times NOI can cover the interest obligation and gives the lender an idea of how much of an income cushion the borrower has in terms of their ability to pay the interest on the loan.
A loan sizing ratio that divides the annual NOI by the annual debt service payment inclusive of both principal and interest.
A loan sizing ratio that divides the property annual NOI by all fixed charges incurred annually. Fixed charges include: all debt service payments and other fixed amounts the borrower incurs, including ground lease and operating lease payments and payments on unsecured debt.
Terms or clauses of loan agreements.
Under a loan contract, these are the things the borrower cannot do.
Under a loan contract, these are the things the borrower must do.
The act of the lender demanding full principal repayment prior to loan maturity.
A cash penalty levied if mortgage principal is prematurely paid down or paid off in full.
The complete prohibition of early loan principal repayment for a specified period of time.
A loan secured by recourse to the assets of the property; if the borrower fails to repay the loan, the secured lender is entitled to foreclose on the collateral to satisfy their claim.
A loan solely secured by the property’s assets; the lender only has recourse to the property’s assets and cannot seize any of the borrower’s personal assets to recoup any principal not repaid.
If the loan is non-recourse, if the property value falls below the loan balance, the borrower can, de facto, sell the property to the lender for forgiveness of the loan balance. In this way the outstanding balance is essentially a put option for the borrower.
The lender secures the loan against both the property as well as the personal assets of the borrower. If the borrower does not repay the loan, the lender can look to possess and liquidate the borrower’s personal assets to cover any losses on their own, with the specifics of the process covered by state and federal bankruptcy codes.
Within a loan contract, a formal pledge by the borrower promising certain events will occur, such as construction completion and leasing up a new development to a certain level of occupancy.
A periodic request from a construction loan borrower that the lender advance funds, based on project costs incurred for which the borrower has been invoiced or for which they have already paid.
A request from a construction contractor or service provider for payment for work put in place or services rendered.
Written statement by a landlord to a tenant defining the scope of their space’s interior construction.
A loan’s constant payment factor relative to the loan amount, given a known interest rate and term of amortization.
A repayment of the outstanding principal sum made at the end of a loan period.
A loan clause that allows the lender to take all cash inflows until the borrower’s loan obligations are satisfied.
The schedule over which loan principal is repaid.
A fee the lender charges for processing the loan.
The replacement of one debt facility with another.
What remains available as cash to a borrower when they repay an in-place loan with a loan larger than the outstanding balance of the in-place loan.
A type of loan prepayment penalty that involves a substitution of the collateral: Treasury bonds for the real estate. It requires that the borrower purchases a portfolio of U.S. Treasuries sufficient to make all of the remaining scheduled loan payments.
A loan prepayment penalty in which the lender is made whole on the unpaid interest that they would have received if the borrower had not prepaid.
- Interest Types and Short-Term Versus Long-Term Debt
- Interest Calculation Bases
- Key Loan Sizing Ratios
- Loan-to-Value and Loan-to-Cost
- Debt Yield
- Interest Coverage Ratio
- Debt Service Coverage Ratio
- Fixed Charges Ratio
- Other Key Loan Terms
- Common Negative Covenants
- Prepayment Penalty
- Operating Restrictions
- Additional Debt
- Common Positive Covenants
- EBIT, Cash Flow, or NOI
- Loan Terms
- Loan Points
- The Refi Decision
- Repayment Penalties
- Refinancing in a Down Market