My commercial loan, hard money lending company, Blackburne & Sons, competed this week to buy a discounted first mortgage note on an apartment building. Do you know how to underwrite a discounted note when its a commercial loan? You will after this blog article.
When underwriting a discounted commercial loan, perhaps the most important issue is the interest rate on the note being sold. Private mortgage investors, when deciding whether or not to invest in a commercial real estate loan outside of California (yield requirements are 2% to 3% lower in California), usually insist on a yield of between 12%* and 14%*.
* Gross yield before loan servicing fee. I've been in the hard money mortgage business for 33 years now. Show me a hard money lender that doesn't charge a loan servicing fee of at least 1% to 2%, and I'll show you a hard money lender that will not survive the next recession. I've been preaching this to my fellow owners of hard money shops for years. During the Great Recession, at least 60% (85%?) of all hard money commercial loan companies failed. The handful that didn't fail only survived because they went back to their investors and raised their loan servicing fees to at least 2% per year.
Therefore, when underwriting a discounted commercial loan, you must first discount the loan back to present value at a yield that is appealing to a private mortgage investor. In other words, what is the proper price to pay for this commercial loan for an investor wishing to yield 13%?
When discounting a commercial loan back to present value, much depends on the remaining term of the commercial loan. For example, let's look at an 8% first mortgage commercial loan secured by an office building. If there are just two more years remaining on the note, the discount might not have to be too large.
We said that the investor wishing to buy this commercial first mortgage note wants to earn, say, 13%. Thirteen percent minus 8% equals 5% per year. Five percent per year times the 2 years remaining on term of this commercial loan gives us a rough discount of only around 10 points. I'll teach you a more precise way of calculating this discount in a moment. Right now I want you to focus on the concept that the longer the remaining loan term, usually the larger the discount.
But what if this same 8% commercial loan had 10 more years to run? Just doing some rough calculations, the discount would have to make up for a shortfall in the interest rate of 5% per year. A 5% per year interest rate shortfall times 10 years is a whopping 50 (FIFTY) point discount! Ouch! A far better option in the above case would be to hypothecate the note - in other words, borrow against it - rather than selling it at a discount.
Below are instructions on how to properly and accurately compute the discount on a commercial loan. Don't try to slug through them right now. You can always come back and study this article in detail (bookmark it?) when you have a real deal to underwrite. Instead, just skip right now to the rest of the article below the instructions.
HOW TO COMPUTE A DISCOUNT ON A COMMERCIAL LOAN
How do you compute the discount on a commercial loan properly and precisely? Take out your financial calculator. You will notice that your financial calculator has a row of five buttons:
- N (Stands for Number of payments until the loan balloons.)
- I (Stands for Interest rate. You may have to convert this to monthly.)
- PV (Stands for Present Value or the loan balance)
- PMT (Stands for Payment. Usually this will be monthly)
- FV (Stands for Future Value or balloon payment)
As long as you know four of the five values, you can compute the fifth. In this case, we're trying to figure out how much to pay for this commercial loan. In other words, we are trying to figure out the PV. As long as we know the other four values, we can compute the PV.
Therefore, in the N field, insert the number of months until the maturity date.
In the I field, insert, not the monthly interest rate on the actual commercial loan, but rather 1/12th of the desired yield by your private investors! In this case, you would insert 1/12th of 13%.
In the PMT field, insert the monthly payment. On some financial calculators, you may have to change the sign of the monthly payments from positive to negative, or vice versa. Be careful not to forget the final month's payment. Is it included in the ballon payment? Don't double count, but also don't forget the last monthly payment either.
In the FV field, insert the ballon payment. On some financial calculators, you may have to change the sign from positive to negative, or vice versa. Is the last monthly payment included in the balloon payment? Don't forget it ... but don't double-count it either.
We are now ready to compute the size of the discount. Ask your financial calculator to compute the PV - what you should pay for the commercial loan if you want to yield 13%.
Let's suppose you are trying to buy a $100,000 commercial loan, and you compute the discount to be $17,000. Does this mean that you should pay $83,000 for the commercial loan? No. You have forgotten about the loan fee being charged by your lender and your own loan brokerage fee.
Let's suppose that Blackburne & Sons is charging 4 points, and you are charging a loan brokerage fee of 2 points. Therefore you should subtract from the purchase price of the commercial loan the combined loan fee of 6 points, or in this case, $6,000.
We're still not quite done. There will be closing costs - attorney's fees, title insurance, and recording fees. A good rule of thumb for these costs is 2.5 points for commercial loans with a face value of less than $500,000 and 1.5 points for commercial loans with a face value larger than $500,000.
Therefore we have a $100,000 face value commercial loan, minus a discount of $17,000 to make the yield attractive, minus $6,000 in combined loan brokerage fees, minus $2,500 in closing costs - for a net to the seller of $74,500.
Why would a seller take just $74,500 for his commercial loan? (1) He needs money; and (2) he no longer wants to take the risk that the borrower won't pay.
We are not done yet underwriting the deal. You need to look at the loan-to-value ratio. The end private investor, in our example, is paying $83,000 for the commercial loan ($100,000 minus the $17,000 discount to bring the yield up to 13%). Is this a reasonable loan-to-value ratio? Divide $83,000 by the current value of the property to make sure that it does not exceed 70% LTV.
What is the payment history of the underlying borrower on the commercial loan? The above discussion assumes that the underlying borrower has been paying essentially perfectly. If not, the discount may be significantly larger.
What is the credit of the underlying borrower? Did the original owner of the commercial loan pull a credit report on him? Does the loan package include old tax returns, showing that the underlying borrower was making money, at least when the commercial loan was originally made? Is the property owner-occupied? Does the maker's (the underlying borrower's) business look like it is thriving? Is this a rental property? If so, does it look fully-occupied?
If the answer to all of these questions is yes, the private investor buying the commercial loan may only require an 11% yield, rather than a 13% yield.
One the other hand, if the answers are not so appealing, the discount may have to be larger. That being said, this is a capitalistic world. There is some discount that is large enough to make almost any first mortgage commercial loan worth buying.