Sizing Debt 

Most commercial real estate debt is levered, meaning, investors typically use debt to capitalize real estate development & investment projects. Using debt to fund projects helps boost total project returns, as well as total returns to the equity investors in the projects. While higher returns are nice and all, they come with a set of serious risks. In fact, refinance risk is the most severe, and impactful risk that CRE investors alike all take on when they use debt to capitalize deals. But why? Well, leverage and risk are positively correlated because the higher leverage taken on any one deal, the greater the chance things can go wrong on the backend or exit of the project. Conversely, mortgage loan terms are negatively correlated with refinance risk because the shorter time in which an investor must pay off a lender, the riskier the investment project is.

Business plans often deviate from expectations and underwriting projections given our economy and industry, making things even more challenging, like in today’s investment climate.

If the market cannot meet an investor’s sale or exit valuation projection for a particular project and the loan is coming due, that investor is faced with the decision of selling for less money, or refinancing the debt when the loan term comes do. Stress testing refinances is more of an art than a science, however, it is by far the most important sensitivity analysis to run when looking at a deal. Doing so helps equity partners or borrowers quantify risk for that opportunity based on their projected yield for taking on that much risk in the deal. In lieu of risk, returns don’t mean all that much in the relative world that we live in. In other words, not all risk is treated equally because of opportunity cost and the time value of money. For a deeper dive into risk/reward, check out our blog on the DISCOUNT RATE, here. To illustrate a quick risk/return example, imagine you invest $100,000 into a project that is using 100% equity and no debt to fund the deal, and you receive $200,000 back in 5 years, giving you a 2x multiple on invested capital. All else equal, would you require the same $100,000 net return if the same project used 75% debt from a bank to give you a 2x multiple in 5 years? I sure hope not. If the project did not perform as expected and the borrowers defaulted, the bank could take control of the asset and foreclose on it, wiping away your $100,000. That couldn’t happen if the deal was capitalized with just equity. To quickly gauge whether a project is taking on conservative debt or leverage, an investor can compare the deal’s unlevered IRR (annual return without debt) against its levered IRR (annual return with debt). If the unlevered return comes in below an array of acceptable returns, but the levered projections look strong, then you should scrutinize the project a lot harder as it may be artificially boosting projected returns with risky debt.

The holy grail of debt sizing lies in a metric called the debt service coverage ratio. Loan proceeds are underwritten so that the net operating income of a project exceeds the annual debt service by at least 1.25x, as that is the minimum industry standard coverage. Think of DSCR as cushion for the lender. As an overly simplistic example, if I lent you $100 to use for your business, I would want you to bring in $125 that year to ensure you could pay my required debt service. Same goes for commercial real estate. Depending on the type of lender and loan structure, the required DSCR could be anywhere from a 1.25x to a 1.40x based on either in place, or future income once a business plan is executed. To calculate the annual payment needed to satisfy the DSCR constraints below, lenders use an amortization period (typically 20-30 years) which coincides with the time until the loan is fully paid off. Deals can be sized to interest only DSCRs, or amortizing DSCRs, depending on the loan type and utility of the loan itself. CMBS loans can often be full term interest only loans, in which the loan proceeds are sized to an interest only 1.25 DSCR ratio, granting a borrower higher proceeds. Fannie Mae and Freddie Mac, however, will size and price their permanent loans to different tiers depending on leverage and risk level.

Aside from DSCR, lenders also look at debt yield, which is simply the net operating income divided by the loan amount. The greater the risk the loan has against the collateral, the greater the stabilized debt yield the lenders will require. Lenders want to quantify what their return on total cost would be if they were to take control of the property. In doing so, they can quantify their margin of safety, and potential returns if they were to sell the note, or collateral, to the open market.

In summary, there are many things to consider when placing debt on an acquisition. It is of utmost importance to understand the logic driving the loan proceeds behind the biggest capital partner to any given transaction, who is almost always the senior lender.

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