For the typical real estate investor, the lender is their biggest partner, often contributing 60% to 80% of the capital required for a deal. Thus, how the debt is structured can materially impact the deal returns. In a prior article, we briefly discussed the importance of understanding the debt structure as it relates to the current market environment and the business plan. In today’s quick snippet, we will dive into some of the key debt parameters and loan types to arm you with more tools and knowledge as you evaluate various investments.
The snippet is intended to serve as a quick reference for both active and passive investors. The terminology and material is a bit dense but important to know and understand. Thus, for a faster read, feel free to skip over the terminologies section and jump over to the putting it all together summary in the end.
Key terminologies to understand:
- Loan To Value (LTV): In simple terms, the loan to value represents exactly that – the loan amount divided by the appraised value of the property. Depending on the loan provider, loan type, and property type, LTV ranges between 60% and 80%. The higher the LTV, the more leveraged the property is. While higher leverage yields better returns (as it means the property owner puts less of their own capital into the deal), it also carries higher risk in the event of cash flow compression or property value decline.
- Debt Service Coverage (DSC): DSC equals the NOI divided by the principal and interest debt service. Effectively it measures ability of the cash flow generated by the property (NOI) to service the debt (debt service). Most often lenders would require a min of 1.25x DSC, though this number can range from as low as 1.10x to as high as 1.35x. As an operator, you want to have some cushion relative to the bank covenant level. We typically target a DSC min of 1.5-1.6x. In a worst case scenario, you do not want your DSC to fall below 1.0x, which simply means the property does not generate enough cash flow to cover the minimum debt obligation. If that occurs, the owners would be required to cover the deficit (or take other actions to cure the bank covenant default).
- Debt Yield: Debt yield is calculated as NOI divided by the loan amount. In essence, it represents the inverse of the property’s cash flow leverage position. Lenders may apply this as they determine the loan size.
- Loan sizing: While the most common loan size is based on LTV, it is not uncommon for lenders to size the loan on the lesser of LTV, DSC, and Debt Yield.
- Interest rate: The interest rate on the loan can be fixed (for part or the entire loan tenor) or floating (usually based on an Index like SOFR, BSBY, Prime, etc. plus a loan spread). If you choose a floating rate but are looking for ways to hedge the risk of rising interest rates (very relevant in the current environments) you can use financial derivatives like swaps (fixes the index rate) or options (collars (set a rate floor and a rate cap) or caps (set a cap on how high the rate can increase)) to mitigate such risk.Banks may have capabilities to offer both swaps and options. Other loan providers may only be able to offer only options.
- Tenor: The loan tenor is the loan maturity date. While it is not uncommon to have a 30-year tenor for residential loans (1-4 units), for most commercial real estate the tenor is shorter (3-10 years) leaving a balloon payment due at maturity. This is not something to panic about. In most cases, at maturity the owner would either refinance the property (thereby extending the tenor) or sell the property (thereby paying off the loan with the sale proceeds).
- Amortization: Amortization sets how the loan principal amount is spread over time. For a typical home loan that is 30 years, which matches the loan typical home loan tenor and means the owner has 30 years to fully pay off the loan. For commercial loans, the amortization varies between 20 and 30 years, which means the principal balance is spread over 20-30 years. When the commercial loan amortizing over 25 years matures in 5 years for example, this would leave a balloon payment in the end as the remaining principal balance due essentially has 20 more years left to fully pay off. Most loans amortize on a mortgage style basis, paying more interest in the beginning and less of the principal balance. However, a lender may require a straight line amortization, which divides the loan principal amount by the amortization period to arrive and the monthly principal amount, which will stay the same throughout the tenor of the loan.
- Interest only period: Certain loans may have an option to pay only interest for part of or the entire loan tenor. Needless to state, as this feature does not require the operator to pay down the loan principal, it provides more flexibility (which can be very beneficial for value add properties, which may require a period of time to stabilize).
- Closing costs and fees, including exit fees: These are the typical fees required for diligence and processing the transaction and may include but not limited to – appraisal/environmental/seismic/property condition reports, underwriting fees, lender legal fees, title and title insurance fees, escrow, etc.
- Prepayment penalties: It is not uncommon for loans to have penalties if the loan is paid off prior to the maturity date. When lenders provide the loan they have to carve out committed capital specific for that loan and price the loan based on the risk and tenor in order to achieve their required return. The prepayment penalty compensates the lender for any gap (partially or in full) in the event of an early pay off. Prepayment penalties have varying structures that could range from fixed % of the loan balance, reducing % of the loan balance (e.g. 5-4-3-2-1% of the outstanding loan balance for a 5-year tenor), yield maintenance (typically determined by calculating the present value of the remaining loan payments, with a discount rate equal to the current yield on the U.S. Treasury that matures closest to the loan’s maturity date plus small processing fees), or defeasance (it is quite complex but in simple terms determined by the price of a portfolio of bonds that are sufficient to provide for the remaining loan payments, plus transaction fees to several third parties).
- Different loan types: The two most typical loan structures are bridge and permanent (aka perm). The bridge loan is typically shorter in tenor (1-3 years), has higher leverage (up to 80% LTV), and has more flexibility. It is intended to bridge the period during which an operator is stabilizing the property (conducting the property rehab and raising rents). It might have extension options (one or two). However, those extensions are not guaranteed and usually carry additional fees and may have a different interest rate. The perm option usually has longer tenor (5-10 years).
- Loan providers: The usual loan providers in the commercial real estate space are banks, agencies (Fannie Mae and Freddie Mac), commercial mortgage backed securities providers (CMBS), and insurance companies. They each have varying tolerance of risk and property type requirements; therefore, each will usually have varying loan structures.
- Covenant structure: To monitor loan performance and establish early triggers in the event of property deterioration, most lenders would have loan covenants (financial and reporting). The most typical financial covenant is a minimum DSC. The most typical reporting requirements are the annual operating statement, rent roll as well as any other reports required from the loan guarantor if the loan is recourse. Some lenders (typically the agencies) will also have opening requirements like min property occupancy of 90% for the 90 days preceding close, cap on tenant concentrations, etc.
- Collateral: This is the asset that you pledge to secure the loan. In the event of foreclosure the lender can step in and sell the asset in order to fully or partially pay off the loan balance and eliminate or reduce their losses, respectively. Sometimes a lender may require the owner to cross collateralize certain properties (usually if the subject asset is in a more distressed position). When cross collateralizing properties be careful because you are typically not allowed to pledge properties that are already encumbered by another lender. In addition, if the subject property fails, you are at risk or losing the cross-collateralized properties too.
- Additional collateral support typically includes personal guarantees from the sponsors or key principals. Some lenders (agencies) may also have certain requirements, e.g. the guarantor(s) must possess (combined) liquidity (cash and marketable securities) equal to a minimum of 10% of the loan amount and (combined) net worth equal to the loan amount. When the loan requires a guarantee it is also known as recourse loan.
- Re-margin provisions: This requirement is more typical for banks vs. agencies. It effectively may require the owner to pay down the loan to bring LTV within a certain hurdle in a scenario where market values decline.
Putting that all together:
The loan structure should match your business plan. For example, if you plan to hold the property long term, a perm loan structure (vs. bridge) would be a better fit. Alternatively, you may have a perm loan with built in interest rate only period, if you need that flexibility on the front end. If you have a heavy lift and need the ramp up period to complete the rehab of the units and increase rents, a bridge option may work better (as traditional lenders would typically lend on actual vs. proforma numbers, which the property in turnaround stage might not be able to support at the onset). For bridge loans, however, make sure the operator has a well thought out and well vetted exit plan, as extensions are not guaranteed and nor are favorable refinance/take out loan terms.
In addition, if you plan to refinance the property and believe rates will be lower at the time of refinance, locking in a fixed rate loan with large prepayment penalties might not be the best solution. In that scenario, you may want to consider floating rate loan with a hedge feature. For long term buy and holds and/or in a rising interest rate environment, fixed rates provide a better solution. Either way, if you have a fixed rate loan and decide to refinance the property prior to maturity, make sure the operator is factoring in the prepayment penalties in their calculations and is using conservative refinance rate and LTV assumptions. Agency loans provide a nice supplemental loan feature, which helps avoid the prepayment penalty situation.
You also want to ensure that the operator is factoring in prepayment penalties at exit (e.g. 5 year exit on a loan with a 10 year tenor).
The loan terms should also match one’s risk tolerance. For example, high leverage (LTV) floating rate debt may generate higher returns. However, that usually carries higher risk. Low to moderate leverage usually results in more equity needing to be brought in, which reduces the overall returns but also carries lower risk, especially in the current environment. Fixed rate or hedging the interest rate risk comes with additional cost (there is no free lunch); however, it also helps reduce the overall risk profile of the deal.
Lastly, when investors receive a loan quote at the onset, it is typically presented in a term sheet format. A term sheet is NOT a commitment to lend and subject to the borrower meeting all conditions preceding closing required by the lender AND remains subject to final credit approval. That final credit approval might not arrive until the day of close. For many lenders, the process goes through a loan approval committee, which has a scheduled process and may require multiple meetings, i.e. is not immediate. On occasion, lenders may issue a commitment letter. However, that is not very common. Thus, it is important (especially in a fluid market environment) to frequently check in with your lender throughout the loan process in order to ensure you stay a step ahead of any (material) changes to the loan terms that may impact your deal, structure, and returns.
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.