Problem:
You are a loan officer at JHM Bank headquartered in Atlanta. Dawg-Gone investments has approached you to get a mortgage to finance the purchase of Goodman Place, a one million square foot class A office building in the central business district (CBD) of Atlanta. Dawg-Gone has agreed to pay $140 per square foot to buy Goodman Place.
Dawg-Gone is requesting a loan amount of $105 million. On class A office properties, JHM Bank allows up to 75% loan to value ratio, based on the minimum of the purchase price or the estimated property value. The non-recourse loan is structured as a partially amortizing balloon loan, with amortization of 30 years (annual payments and compounding) and a term of 10 years. Currently JHM is charging 4% on these loans with no origination fees or points.
Market rents for Goodman place are $23/sq. ft. and are expected to grow 2% annually. Strong demand and limited supply have pushed vacancies in Atlanta's CBD to their lowest levels since 2008, so you anticipate vacancies and collections of 16% of potential gross income. Operating expenses and capital expenditures are expected to be 45% and 3% of effective gross income, respectively.
You need to determine whether the requested loan on Goodman Place meets JHM's underwriting eligibility requirements. As mentioned above, the max initial LTV is 75%. JHM also requires a max terminal LTV of 65%. As for income ratios, the minimum debt coverage ratio is 130% and the max break even ratio is 70%. If the loan is held in portfolio there is no debt-yield ratio requirement, but if the loan is packaged into a CMBS the minimum DYR is 10%.
From market research, you determine that the going-in cap rate for class A CBD office space in Atlanta is 6.77%, and that the discount rate for unlevered property of this risk is 8.01%.The holding period for the borrower's investment is five yearsand you estimate that the going-out cap rate will be 6.90%. Selling expenses are expected to be 4% of the sales price.
Create a pro-forma forma for Goodman Place and answer the following questions.
1) What is the LTV that Dawg-Gone is applying for (using the purchase price)?
2)a. What is the estimated value of Goodman Place using direct capitalization?
b. What is the initial LTV of the requested loan using the direct capitalization method and does the loan meet JHM's underwriting guidelines?
3) a. What is the estimated value of Goodman Place using the discounted cash flow method?
b. What is the initial LTV of the requested loan using the DCF method and does the loan meet JHM's underwriting guidelines?
4) Does the loan meet the terminal LTV requirements of JHM? (Hint: you need to use the remaining mortgage balance at the end of 5 years to calculate the terminal LTV).
5) a. What is the DCR, BER, and DYR in the first year for Goodman Place?
b. According to these income ratios, does the loan qualify for JHM's portfolio lending?
c. Can the loan be packaged into a CMBS (explain)?
6) What is Dawg-Gone's cash-on-cash return in the first year of the project? Would Dawg-Gone want to take on the project if cash-on-cash returns for similar risk projects is 10%?
7) What is the IRR for Dawg-Gone's equity investment? Would they want to take on the investment if their OCC is 18%?
8) Suppose that market cap rates increase over the five year holding period (e.g., prices drop) and that at the time of sale cap rates are 10.5%.
a. What is the sale price at the end of year 5 using the new cap rate (assume NOI hasn't changed)?
b. What is the IRR to Dawg-Gone if they pay off the mortgage?
c. Assuming no costs of default (e.g., reputation), will Dawg-Gone pay the mortgage or default (explain)?
9) Would your answer to #8 part c) change if the mortgage was an IO loan (explain)?