My sons were reading a newsletter issued by a commercial mortgage banking firm that is a correspondent for a number of life companies. Confused, they asked me what the following sentence meant:
"Although non-recourse options are more the exception than the rule, they are quoting low LIBOR +250 terms on an interest only basis down to a break-even going-in coverage."
Back in the old days (the 1970's and earlier) it took a computer the size of a small bedroom about 7 minutes to figure out the monthly payments on a fully-amortized loan. Obviously loan officers could not carry around a 2-ton computer. They therefore used "loan constants".
You will recall that a "loan constant" is the monthly payment on an imaginary loan of $1,000 at a particular interest rate and amortization. For example, the monthly payment on a loan of $1,000 at 4.5% interest and fully-amortized over 25 years is $5.56/month. In other words, if you borrow $1,000 at 4.5% interest and pay back $5.56 every month for 25 years the loan will be paid in full.
The office manager at the mortgage company would announce to all of its loan officers that Freddie Mac had just raised its interest rate from 4.375% to 4.5%. The new loan constant was therefore $5.56. If a borrower was borrowing $200,000 rather than just $1,000; the loan officer would simply multiply $5.56 (the monthly payment on a $1,000 loan) by 200 to get the monthly payment on a $200,000 loan at 4.5% interest and fully-amortized over 25 years.
Modernly, when commercial loan officers talk about "loan constants", they are doing so to tell the reader what interest rate and amortization they used when they computed their debt service coverage ratio. For example, a loan officer might say, "The debt service coverage ratio is 1.42 based on a 4.5%, 25-year constant." The constant matters a lot. That same property might only have a 1.02 debt service coverage ratio using a 6.75%, 20-year constant. A debt service coverage ratio of just 1.02 is not good enough for most commercial lenders.
What if the proposed commercial loan is an interest-only loan? The monthly interest-only payment on a loan of $1,000 at 4.5% is $3.75 per month. So if a loan officer is talking with his boss about an interest-only bridge loan, he might say, "Boss, the debt service coverage ratio on this deal is 1.57 based on a 4.5% interest-only constant."
So the sentence, "Although non-recourse options are more the exception than the rule, they are quoting low LIBOR +250 terms on an interest only basis down to a break-even going-in coverage," means in English that this commercial lender is making commercial loans at one-month LIBOR (just 0.25% today) plus 2.50%, which works out to a 2.75% interest rate, with the rate being readjusted monthly. The loan has interest-only payments, and the lender is only requiring a 1.0 debt service coverage ratio (break-even cash flow) based on a 2.75% interest-only constant. The borrower would also probably have to personally guarantee the loan.
Phew! There were a lot of moving parts in that one little sentence.
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