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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   June 2005

When tracking rates, timing is everything

c_2006-06_Eisendrath_spotThe underwriting process sometimes seems like “magic,” but it does not have to be. You can determine available loan proceeds simply by using your financial calculator.

Real-estate professionals follow interest rates closely because fluctuations can dictate available loan proceeds. They track three key indexes: LIBOR, prime and the 10-year United States Treasury.

LIBOR and prime are important because short-term loans such as construction and bridge loans are priced over these indexes. The 10-year Treasury is significant because many borrowers who lock in historically low interest rates have chosen a 10-year term. Although the 10-year Treasury has risen recently, it still is well below the 30-year average of 5.16 percent.

Borrowers, mortgage bankers and lenders know that timing is the most-important thing in real estate. Everyone wants to buy at the bottom of the market and sell at the top. The timing of obtaining a loan is also important for fixedor floating-rate loans.

Fixed rate

The 10-year Treasury fluctuates constantly, and locking in a rate at the right time can result in significant savings in ongoing debt service. Required debt-service coverage varies based on product type, market and tenancy.

Unfortunately, mortgage bankers and borrowers can find that a rise in interest rates results in higher debt service. In turn, this lowers debt-service coverage. If maximum proceeds are desired and interest rates rise, the lender might reduce proceeds to maintain a certain debt-service-coverage level.

Although many loan applications spell this out, borrowers refer to the practice as retrading. Lenders consider it a market change.

Floating rate

Interest rates affect floating-rate loans in a different way. As the name implies, a fixed-rate loan has a fixed interest rate, which maintains the debt service at a constant level throughout the loan term. Typically, floating-rate loans adjust monthly based on index changes. As a result of these index fluctuations, lenders must take a rise in interest rates into consideration.

No lender can predict future interest rates, so deals must be underwritten with a cushion to provide lenders enough debt-service coverage through the loan term. For example, if the LIBOR is 3 percent, a lender could assume the LIBOR is an average of 5 percent in a three-year loan term. For an existing, income-producing property where a borrower is seeking a value-add execution, a rise in the short-term interest rate between underwriting and closing can reduce debt-service coverage. This situation forces a lender to reduce proceeds or add an interest reserve to the loan. An interest reserve is a portion of the total loan amount that is available post-closing to cover cash-flow shortfalls. These shortfalls result in the inability to pay debt service monthly.

Loan sizing

Borrowers often want to know what loan amount a property will support. For stabilized income-producing properties, lenders frequently will size a loan to a Fitch constant. While an actual constant simply is the annual interest and amortization divided by the loan amount, the Fitch constant is an artificial loan constant applied to the loan amount.

After sizing the loan, the lender then focuses on the debt-service coverage based on the in-place cash flow. For example, a lender might be underwriting a grocery-anchored retail center for a 10-year term with a 30-year amortization. Assuming the 10-year Treasury is 5 percent and the spread is 100 basis points, the interest rate is 6 percent, and the loan constant is 7.19 percent.

Instead of focusing solely on the debt-service coverage at this constant, a lender will use a stress constant typically between 9.3 percent and 10.09 percent. The lender seeks a debt-service coverage between 0.85 and 0.95 times, based on this stress constant. With interest rates rising, lenders are seeking minimum debt-service coverage between 1.2 and 1.35 times that of the actual debt-service on a 10-year loan.

The same concept applies to unstabilized properties. The lender, however, focuses on the debt-service coverage once the property is stabilized. For example, if a borrower purchases a 50-percent-leased office building and plans to bring the building to a 95-percent-occupancy level by the end of the third year, the lender will size the loan using a stress constant on the stabilized income. The resulting loan proceeds available from the refinance must be more than the existing loan amount. Otherwise, the borrower will have to refinance the property out-of-pocket.

Remember: The lender will want to use market assumptions for income and expenses. Above-market rents will be reduced to reflect current-market rents, while the lender will use the greater of the actual or market vacancy. Operating-expense figures must reflect the market’s cost of operating the property. That is, if the current owner only is collecting a management fee of 2 percent, and the market-management fee is 4 percent, the lender will assume a 4-percent management fee. 


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