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CHAPTER 16
Commercial Mortgage Types and Decisions
Test Problems
1. Due-on-sale clauses are included in commercial mortgages primarily to protect
lenders from:
2. Consider a 30-year, 7 percent, fixed rate, fully amortizing mortgage with a yield
maintenance provision. Relative to this mortgage, a 10-year balloon mortgage
with the same interest rate and yield maintenance provisions will primarily reduce
the lender’s:
3. An interest-only balloon mortgage loan is commonly referred to as a(n):
4. The acquisition price of a property is $380,000. The loan amount is $285,000. If
the property’s NOI is expected to be $22,560, operating expenses $12,250, and
the annual debt service $19,987, the debt yield ratio (DYR) is approximately
equal to:
5. Which of the following statements is most accurate?
b. Joint ventures usually decrease the amount of equity capital the
6. Commercial mortgage borrowers may decide to prepay the principal on their loan
even if they face prepayment penalties. One way that lenders protect themselves
from prepayments in such circumstances is by requiring the borrower who
prepays to purchase for the lender a set of U.S. Treasury securities whose coupon
payments replicate the cash flows the lender will lose as a result of the early
retirement of the mortgage. This process is referred to as:
7. Using financial leverage on a real estate investment can be for the purpose of all
of the following except:
8. Which of these ratios is an indicator of the financial risk for an income property?
9. If the property’s NOI is expected to be $22,560 operating expenses $12,250, and
the debt service $19,987, the debt coverage ratio (DCR) is approximately equal
to:
10. With a mezzanine loan:
c. the borrower’s promise to pay is secured by the equity interest in the borrower’s
Study Questions
1. Discuss several differences between long-term commercial mortgages and their
residential counterparts.
Solution: Commercial mortgages have shorter terms than residential mortgages;
five to ten- year terms are common for commercial mortgages and residential
2. Answer the following questions on financial leverage, value, and return:
a. Define financial risk
b. Should the investor select the origination LTV that maximizes the IRR on
equity? Explain why or why not.
Solution:
a. Financial risk refers to the risk that NOI will be less than debt service. A
b. Higher expected returns are gained from additional leverage but the
average return per unit of risk decreases as leverage increases. Leverage
maximizes return when a property is performing well but amplifies the
3. Distinguish between recourse and nonrecourse financing.
Solution: When a note is used and the borrower has personal liability, the
arrangement is known as recourse financing. The borrower has personal
responsibility for recourse debt, and, upon default and foreclosure, the borrower is
4. Explain lockout provisions and yield-maintenance agreements. Does the
inclusion of one or both of these provisions affect the borrower’s cost of debt
financing? Explain.
Solution: A lockout provision prohibits prepayment of a commercial mortgage
over a specified period after the origination of the mortgage. This provision
A yield-maintenance agreement is another mechanism for creating a prepayment
penalty. If interest rates decline and borrowers could prepay at par, lenders would
have to reinvest the remaining loan balance at current (lower) rates. The
The borrower’s cost of debt financing is effectively increased because of these
provisions. Unlike residential borrowers, who generally have the ability to prepay
5. Assume the annual interest rate on a $500,000 7-year balloon mortgage is 6
percent. Payments will be made monthly based on a 30-year amortization
schedule.
a. What will be the monthly payment?
b. What will be the balance of the loan at the end of year 7?
c. What will be the balance of the loan at the end of year 3?
d. Assume that interest rates have fallen to 4.5% at the end of year 3. If the
remaining mortgage balance at the end of year 3 is refinanced at the 4.5
percent annual rate, what would be the new monthly payment assuming a
27-year amortization schedule?
e. What is the difference in the old 6 percent monthly payment and the new
4.5 percent payment?
f. What will be the remaining mortgage balance on the new 4.5 percent loan
at the end of year 7 (four years after refinancing)?
g. What will be the difference in the remaining mortgage balances at the end
of year 7 (four years after refinancing)?
h. At the end of year 3 (beginning of year 4), what will be the present value
of the difference in monthly payments in years 4-7, discounting at an
annual rate of 4.5 percent?
i. At the end of year 3 (beginning of year 4), what will be the present value
of the difference in loan balances at the end of year 7, discounting at an
annual rate of 4.5 percent?
j. At the end of year 3 (beginning of year 4), what will be the total present
value of lost payments in years 4-7 from the lender’s perspective?
k. If the mortgage contains a yield maintenance agreement that requires the
borrower to pay a lump sum prepayment penalty at the end of year 3 equal
to the present value of the borrower’s lost payments in years 4-7, what
should that lump sum penalty be?
Solution:
a. Based on a 30-year amortization schedule, the monthly payment is
b. The balance of the loan at the end of year 7 is $448,197 (solving for the
c. The balance of the loan at the end of year 3 is $480,420 (solving for the
d. The new monthly payment assuming a 27-year amortization schedule is
e. The new loan payment on the new 4.5 percent loan is $433.65 less than
f. The remaining mortgage balance on the new 4.5 percent loan at the end of
g. The difference in the remaining mortgage balances at the end of year 7
(four years after refinancing) is as follows: The balance at year seven for
h. At the end of year 3 (beginning of year 4), the present value of the
differences in monthly payments in years 4-7, discounting at an annual
i. At the end of year 3 (beginning of year 4), the present value of the
differences in loan balances at the end of year 7, discounting at an annual
j. At the end of year 3 (beginning of year 4), the total present value of lost
k. The lump sum payment should be 25,532 ($19,017 + $6,515).
6. Consider the stand-alone locations favored by Walgreens for locating their
drugstores. In most cases, Walgreens does not own these properties. Instead, they
lease the properties on a long-term basis from institutional owners. What does
Walgreens gain by leasing instead of owning? What do they lose?
Solution: Walgreens obtains the use of a structure that is well suited to its needs.
They gain the benefit of investing their funds in its core business operations rather
7. Consider the following table of annual mortgage rates and yields on 10-year
Treasury securities.
a. What was the average annual spread on mortgage rates relative to the
10-year Treasury securities over the 1990-2005 period?
b. What was the correlation between annual mortgage rates and Treasury
yields over the 1990-2005 period?
Solution:
a. The average annual spread on mortgage rates relative to the 10-year
b. The correlation between annual mortgage rates and yields over the
8. List and briefly describe the typical items included in a commercial mortgage loan
submission package.
Solution:
Loan submission packages provide lenders with the information they need to
quickly evaluate the borrower’s loan request, including information on type, size,
9. What is the difference in the present value of these two loan alternatives? Assume
the appropriate discount rate is 6 percent.
Solution: The difference in NPVs == 0; there is no difference in the PV of the
Present value of Option A:
N=5 I/YR = 6.0 PV=? PMT=42,000 FV=700,000
Total PV = up-front financing costs + PV of payments
Present value of Option B:
N=5 I/YR = 6.0 PV=? PMT=45,000 FV=750,000
Total PV = up-front financing costs + PV of payments
THIS IS INCORRECT! FIRST, THE PROBLEM SAYS THE LOANS WILL BE
OUTSTANDING FIVE YEARS. ALSO, I SHOULD NOT FACTOR IN THE
INTIAL EQUITY INVESTMENT.
Present value of Option A is $1,050,000: initial equity ($300,000) + upfront
Present value of Option B is $1,000,000: initial equity ($250,000) + present value
10. You are considering the purchase of an industrial warehouse.
a. Calculate the overall rate of return (or “cap rate”)
b. Calculate the debt coverage ratio.
c. What is the largest loan that you can obtain (holding the others terms
constant) if the lender requires a debt service coverage ratio of at least 1.2?
Solution:
a. The overall rate of return (or “going-in” cap rate) is 10.8% (NOI of
b. The debt coverage ratio is computed below:
c. The maximum amount of interest that you can afford to pay based on the
11. Distinguish among land acquisitions loans, land development loans, and
construction loans. How would you rank these three with respect to lender risk?
Solution: Land acquisition loans finance the purchase of raw land. Land
development loans finance the installation of the onsite and offsite improvements
12. Discuss the potential advantages of a miniperm loan from the prospective of the
developer/investor, relative to the separate financing of each stage of the
development.
Solution: The existence of a single lender and a single application process
simplifies the financing process. Miniperm loans enable developers to proceed
13. You are considering purchasing an office building for $2,500,000.
a. What is the implied first-year overall capitalization rate?
b. What is the expected debt coverage ratio in year 1 of operations?
c. If the lender requires DCR to be 1.25 or greater, what is the maximum
loan amount?
d. What is the debt yield ratio?
Solution:
a. PGI $450,000
Vacancy and collections (40,500)
EGI 409,500
the implied first-year overall capitalization rate is $237,510/$2,500,000 or
0.095
b. The expected debt coverage ratio in year 1 of operations is 1.72
c. If the lender requires DCR to be 1.25 or greater, the maximum loan
amount is determined by first calculating the maximum debt service
d. The loan amount is $1,875,000 (0.75 x $2,500,000). Therefore, the debt
