FIN 591 Week 3 Debt and Equity Financing Example

How Much to Borrow on Mission Oaks: Sizing an Agency Loan by Coverage, Facing Costly Debt in 2025 and Structuring the Equity With an Operating Partner

[Student Name]

University of Phoenix

FIN/591: Real Estate Investment

Week 3 Assignment

[Instructor Name]

[Date]

Mission Oaks Apartments, the lender, the operating partner and all figures are composites written for a model paper; loan terms and research findings come from the sources listed and are stated generally.

The composite Texas family office plans to bid up to about $16.25 million for Mission Oaks, the composite 120-unit San Antonio apartment community valued in Week 2. With closing costs of about 1.5 percent and a renovation budget of $720,000 over two years, the total cost approaches $17.2 million. The family office wants to limit its equity commitment and has two loan quotes. How much a lender will lend, and what that loan does to returns, depends less on the price than on the property's income and today's interest rates. This paper sizes the loan and structures the equity.

Two Loan Offers

An agency lender, originating for one of the government-sponsored housing finance companies, offered a ten-year fixed-rate loan at about 6.0 percent, with two years of interest-only payments and then 30-year amortization, up to 70 percent of value, nonrecourse except for standard carve-outs for fraud and environmental problems, with a declining prepayment penalty. A regional bank offered up to 75 percent of value at about 6.5 percent with 25-year amortization, a five-year term and a personal guarantee from the family office. The agency loan's longer term, lower rate and nonrecourse terms suit a ten-year hold.

Sizing the Loan

The agency lender underwrites net operating income after reassessing property taxes, about $895,000, and sets a coverage floor: income has to cover the amortizing payments one and a quarter times over. That allows annual payments of about $716,000. At 6.0 percent with 30-year amortization, the mortgage constant, annual payment per dollar of loan, is about 7.19 percent, so the maximum loan is about $716,000 divided by 0.0719, or roughly $10.0 million. At 70 percent of the $16.25 million price, the loan could be $11.4 million. Coverage binds first, at about 61.5 percent of price (Brueggeman & Fisher, 2018).

The Debt Yield

Lenders also look at debt yield, net operating income divided by the loan amount, because it does not depend on interest rates or amortization. At $10.0 million, the debt yield is about 8.95 percent, above the 8 percent minimum many lenders now require. Had the buyer insisted on the full 70 percent loan, the debt yield would fall to about 7.9 percent, below that floor, a second reason the larger loan is unavailable. Debt yield gives the lender a sense of its return if it had to take the property back.

Costly Debt

At $16.25 million, Mission Oaks' cap rate on adjusted income is about 5.5 percent. The mortgage constant during amortization is about 7.2 percent, and even during the interest-only years the cost is 6.0 percent. Because each borrowed dollar costs more than the property yields, borrowing initially lowers the cash yield on equity. In year one, after $600,000 of interest-only payments, cash flow to equity of about $295,000 on about $6.5 million of equity is a cash-on-cash yield of about 4.5 percent, below the 5.5 percent an all-cash buyer would earn. This condition, rare before 2022, became common in many markets as rates rose faster than cap rates.

Why Borrow Anyway?

Borrowing still helps if income and value grow. The renovation plan adds about $120,000 of income by year three, and rents are projected to grow 3 percent a year once new supply is absorbed. As income grows while the loan payment stays fixed, the cash yield on equity rises, to about 5.4 percent by year three, and value appreciation accrues to equity. Over a ten-year hold, the projected return on equity is about 10.5 percent a year with the loan versus about 8.1 percent without it. The borrowing adds return only because of expected growth, which makes it a bet on the business plan.

The Risk Debt Adds

Debt magnifies losses as well as gains. If the property's value fell 20 percent, an all-cash buyer would lose 20 percent of equity; with debt at 61.5 percent of price, the buyer would lose about half. Titman and Torous (1989) showed that commercial mortgage default risk depends on the relationship between property value and loan balance, which is why lenders limit loan size and why nonrecourse loans protect borrowers' other assets.

Comparing the Two Loans Under Stress

The bank loan would allow about $12.2 million of debt at 75 percent of price, reducing equity by about $2 million, but its five-year term would require refinancing in year five, possibly at higher rates or lower values, and its personal guarantee would expose the family office's other assets. If values fell 15 percent by year five, the bank loan's balance would exceed the 75 percent refinancing limit, forcing the family office to add equity at a bad time. The agency loan's ten-year term avoids that refinancing risk during the planned hold. The analyst valued the bank loan's higher early return at less than the risk it adds.

Interest-Only Years

Two years of interest-only payments raise early cash flow while renovations are under way, but they delay principal reduction, so the loan balance stays at $10.0 million longer and the buyer builds equity only through appreciation in those years. The analyst confirmed that coverage remains about 1.49 times when amortization begins in year three, because renovated units will be producing higher rents.

Reserves and Lender Requirements

The agency lender will require monthly deposits for property taxes and insurance, an upfront repair reserve for the roofs identified in diligence and a replacement reserve of about $300 per unit a year. These reserves reduce cash available for distribution but protect both lender and owner from surprise costs. The pro forma includes them.

The Equity Partnership

The family office will partner with a San Antonio operating partner experienced in apartment renovations. The operator will invest 5 percent of the equity, about $325,000, and manage the renovation and property. Distributions follow a waterfall: first, all investors receive their capital and an 8 percent preferred return; next, cash is split 80 percent to the investors and 20 percent to the operator until investors reach a 12 percent return; above that, the split becomes 70 and 30. The promote rewards the operator for performance and aligns its interests with the family office's (Geltner et al., 2014).

What the Structure Means for Returns

At the projected 10.5 percent property-level return on equity, the second hurdle is not reached, so the operator earns a modest promote and the family office's return is a little above 10 percent after the split.

Conclusion

Debt service coverage limits the agency loan to about $10.0 million, about 61.5 percent of price, and today's rates create a negative spread between borrowing cost and yield at first, cutting early cash yields. Growth from renovations and rents makes borrowing pay over a ten-year hold, raising the projected return from about 8.1 to about 10.5 percent at the cost of greater risk. A partnership with a preferred return and tiered promote aligns the operator with the family office.

References

Brueggeman, W. B., & Fisher, J. D. (2018). Real estate finance and investments (16th ed.). McGraw-Hill Education.

Geltner, D. M., Miller, N. G., Clayton, J., & Eichholtz, P. (2014). Commercial real estate analysis and investments (3rd ed.). OnCourse Learning.

Titman, S., & Torous, W. (1989). Valuing commercial mortgages: An empirical investigation of the contingent-claims approach to pricing risky debt. The Journal of Finance, 44(2), 345-373. https://doi.org/10.1111/j.1540-6261.1989.tb05061.x