Commercial Mortgage Types and Decisions

Study Questions

1. Discuss several differences between long-term commercial mortgages and their residential counterparts.

2. Answer the following questions on financial leverage, value, and return:
a. Define financial risk
b. Should the investor select the origination LTV that maximizes the IRR on equity? Explain why or why not.

3. Distinguish between recourse and nonrecourse financing.

4. Explain lockout provisions and yield-maintenance agreements. Does the inclusion of one or both of these provisions affect the borrower's cost of debt financing? Explain.

5. Assume the annual interest rate on a $500,000 7-year balloon mortgage is 6 percent. Payments will be made monthly based on a 30-year amortization schedule.

a. What will be the monthly payment?
b. What will be the balance of the loan at the end of year 7?
c. What will be the balance of the loan at the end of year 3?

d. Assume that interest rates have fallen to 4.5% at the end of year 3. If the remaining mortgage balance at the end of year 3 is refinanced at the 4.5 percent annual rate, what would be the new monthly payment assuming a 27-year amortization schedule?

e. What is the difference in the old 6 percent monthly payment and the new 4.5 percent payment?

f. What will be the remaining mortgage balance on the new 4.5 percent loan at the end of year 7 (four years after refinancing)?

g. What will be the difference in the remaining mortgage balances at the end of year 7 (four years after refinancing)?

h. At the end of year 3 (beginning of year 4), what will be the present value of the difference in monthly payments in years 4-7, discounting at an annual rate of 4.5 percent?

i. At the end of year 3 (beginning of year 4), what will be the present value of the difference in loan balances at the end of year 7, discounting at an annual rate of 4.5 percent?

j. At the end of year 3 (beginning of year 4), what will be the total present value of lost payments in years 4-7 from the lender's perspective?

k. If the mortgage contains a yield maintenance agreement that requires the borrower to pay a lump sum prepayment penalty at the end of year 3 equal to the present value of the borrower's lost payments in years 4-7, what should that lump sum penalty be?

6. Consider the stand-alone locations favored by Walgreens for locating their drugstores. In most cases, Walgreens does not own these properties. Instead, they lease the properties on a long-term basis from institutional owners. What does Walgreens gain by leasing instead of owning? What do they lose?

7. Consider the following table of annual mortgage rates and yields on 10-year Treasury securities.

a. What is the average annual spread on mortgage rates relative to the 10-year Treasury securities?
b. What is the correlation between annual mortgage rates and Treasury yields over the 1990-2005 period?

8. List and briefly describe the typical items included in a commercial mortgage loan application package.

9. List at least six characteristics of a commercial loan application that the lender should carefully evaluate.

10. What is the difference in the present value of these two loan alternatives? Assume the appropriate discount rate is 6 percent.

11. You are considering the purchase of an industrial warehouse.
a. Calculate the overall rate of return (or "cap rate")
b. Calculate the debt coverage ratio.
c. What is the largest loan that you can obtain (holding the others terms constant) if the lender requires a debt service coverage ratio of at least 1.2?

12. Distinguish among land acquisitions loans, land development loans, and construction loans. How would you rank these three with respect to lender risk?

13. Discuss the potential advantages of a miniperm loan from the prospective of the developer/investor, relative to the separate financing of each stage of the development.

14. You are considering purchasing an office building for $2,500,000.

a. What is the implied first-year overall capitalization rate?
b. What is the expected debt coverage ratio in year 1 of operations?
c. If the lender requires DCR to be 1.25 or greater, what is the maximum loan amount?
d. What is the break-even ratio?