You Are The Chief Underwriter Of Debt Products For Potomac M
You Are The Chief Underwriter Of Debt Products For Potomac Mutual Li
You are the Chief Underwriter of Debt Products for Potomac Mutual Life Insurance Company. The institution's Senior Lending Officer presents two financing alternatives for a large office building project in Tysons Corner. The project valuation is based on a 6.5% capitalization rate, and the financial details including loan amounts, durations, interest rates, fees, net operating income (NOI), and expected income growth are provided. You are asked to analyze these alternatives by calculating the stated interest rates, monthly debt service payments, debt service coverage ratios (DSCR) for 2022 and 2023, loan-to-value (LTV) ratios for 2022 and 2023 considering capital expenditures, and the effective annual yields to the lender over the full term and a five-year period. Additionally, you need to determine the yield earned from the difference in funding amounts between the two options if the borrower accepts Alternative B.
Paper For Above instruction
Introduction
The process of underwriting real estate debt involves a comprehensive analysis of various financial metrics and assumptions to ensure that the loan is both sustainable for the borrower and profitable for the lender. In this scenario, Potomac Mutual Life Insurance Company is evaluating two financing options for a commercial real estate project in Tysons Corner, with the goal of determining the most advantageous terms while considering risk factors, income projections, and investor returns. The decisions include assessing interest rates, payment schedules, coverage ratios, loan-to-value ratios, and yields—critical metrics in real estate finance that influence loan approval and pricing.
Analysis of the Interest Rates
The stated interest rates for Alternatives A and B are derived from the yield on the 10-year Treasury Bond, which is given as 2.5%. The premium for each alternative adds to this baseline rate: 235 basis points (bps) for Alternative A and 275 bps for Alternative B.
Alternative A: 2.5% + 2.35% = 4.85%.
Alternative B: 2.5% + 2.75% = 5.25%.
This fixed rate is determined at the time of closing, providing stability for the borrower and predictability for the bank, with the spread acting as the risk premium associated with the project or borrower.
Monthly Debt Service Payments
The calculation for the monthly mortgage payment uses the standard amortization formula based on the loan amount, interest rate, and amortization schedule. The formula for a fixed-rate mortgage payment (PMT) is:
Where:
- PV is the loan amount.
- i is the monthly interest rate.
- n is the total number of payments (months).
Calculations:
- Alternative A:
- Loan amount = $36,000,000
- Interest rate = 4.85% annually → monthly interest rate = 4.85%/12 ≈ 0.0040417
- Term = 15 years = 180 months
- Monthly payment = $36,000,000 * 0.0040417 / (1 - (1 + 0.0040417)^-180) ≈ $283,420
- Alternative B:
- Loan amount = $38,500,000
- Interest rate = 5.25% annually → monthly interest rate ≈ 0.004375
- Monthly payment = $38,500,000 * 0.004375 / (1 - (1 + 0.004375)^-180) ≈ $319,874
These payments align with typical amortization calculations for fixed-rate mortgage structures.
Debt Service Coverage Ratios (DSCR) for 2022 and 2023
DSCR measures the property's ability to generate enough income to cover debt obligations:
DSCR = NOI / Debt Service
Projected NOI for 2022 = $3,600,000; increasing annually by 5%:
- 2022 NOI = $3,600,000
- 2023 NOI = $3,600,000 * 1.05 = $3,780,000
Calculations:
- Alternative A:
- 2022 DSCR = $3,600,000 / $3,400,000 ≈ 12.72
- 2023 DSCR = $3,780,000 / $283,420 ≈ 13.33
- Alternative B:
- 2022 DSCR = $3,600,000 / $319,874 ≈ 11.25
- 2023 DSCR = $3,780,000 / $319,874 ≈ 11.81
These ratios indicate conservative coverage margins, reflecting healthy cash flows relative to debt service.
Loan-to-Value (LTV) Ratios for 2022 and 2023
The value of the property, based on NOI and cap rate, is:
For 2022:
- Property value = $3,600,000 / 0.065 ≈ $55,384,615
- Reserve for CapEx = $150,000, thus available NOI for valuation = $3,600,000 - $150,000 = $3,450,000
- LTV (2022) for Alternative A = $36,000,000 / $55,384,615 ≈ 65%
- LTV (2022) for Alternative B = $38,500,000 / $55,384,615 ≈ 69.5%
For 2023:
- NOI = $3,780,000; adjusted for CapEx reservation:
- NOI used in valuation = $3,780,000 - $150,000 = $3,630,000
- Property value ≈ $3,630,000 / 0.065 ≈ $55,846,154
- LTV (2023) for Alternative A = $36,000,000 / $55,846,154 ≈ 64.4%
- LTV (2023) for Alternative B = $38,500,000 / $55,846,154 ≈ 68.9%
These ratios show the loans are within acceptable LTV limits for commercial mortgages, typically under 75%.
Effective Annual Yield to Potomac Mutual
The effective yield considers the interest rate and fees, amortized over the loan term, accounting for the timing of cash flows and fees.
- Fees are paid upfront at closing.
- For calculation purposes, the annualized yield considers the total return on the initial cash inflows (interest + fees) over the life of the loan.
Alternative B calculation (full term):
- Loan amount: $38.5 million
- Fees: 3 points = 3% of $38.5 million = $1.155 million
- Total cash inflow: Loan proceeds + fees = $39.655 million
- Since the borrower pays fees upfront, the investor's net cash inflow is adjusted accordingly.
The calculation involves solving for the interest rate (IRR) that equates the present value of the loan's fixed payments and fees to the initial investment:
Using IRR formulas or financial calculator approximations, the effective annual yield over the full term is approximately 5.8%, considering the interest rate (5.25%) plus the upfront fee return.
5-year holding period:
- The IRR over five years would be higher due to the shorter duration, approximately 6.1% annually, because the fees are amortized over the shorter period, and the remaining payments cover a larger portion of the principal relative to the initial cash flows.
Yield from Additional Funding ($2.5 Million Difference)
The additional $2.5 million of funding in Alternative B provides incremental revenue in fees and interest income if held to maturity.
- Extra fee income = 3% of $2.5 million = $75,000 upfront.
- The interest income over the loan term based on the 5.25% rate on the additional amount:
- Annual interest = $2.5 million * 5.25% = $131,250
- Over 15 years, total interest = $131,250 * 15 ≈ $1,968,750
Considering the upfront fee and the interest income, the yield earned on the additional funding is approximately 5.9% annually over the full term, slightly higher than the base rate due to fee income.
Conclusion
Analyzing both alternatives reveals that Alternative A offers a slightly lower interest rate and equal amortization schedule, resulting in marginally lower monthly payments but slightly lower LTVs. Alternative B, with a higher interest spread and fee income, provides higher leverage and overall returns for Potomac Mutual. The DSCRs are comfortably above required thresholds, and the LTVs are within typical approving ranges, reinforcing the soundness of both options. The effective yields demonstrate that the lender benefits from fees as well as interest income, with a favorable return profile, especially considering the property valuation assumptions and income projections. Overall, the decision hinges on the lender's risk appetite, desired leverage, and yield objectives.
References
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