You’re trying to obtain financing for an office building you’re purchasing. The lender has agreed to originate a loan which carries a 6.75% interest rate, a 30-year amortization, and calls for annual (not monthly) payments. The lender isn’t concerned about either the Loan-to-Value or the Loan-to-Cost ratios, but they insist on a minimum Debt Service Coverage Ratio of 1.25. The office building’s stabilized net operating income is $240,000 per year and your initial request is for a $2.6 million loan.
(a) Looking only at the Debt Service Coverage Ratio requirement, will the lender approve your proposed $2.6 million loan? Explain your reasoning and show your work.
(b) What is the maximum loan size which would still satisfy the lender’s Debt Service Coverage Ratio restriction? Explain your reasoning and show your work.
(c) Your business partner finds another bank which seems to be offering a better deal: the loan carries a (much lower) 6.00% interest rate, a 15 year amortization schedule, and the bank requires a 1.30 minimum Debt Service Coverage Ratio you found.
“It’s a no-brainer,” he says, “We should take it.”
Why might the loan with the lower interest rate turn out to be less desirable than the first loan you reviewed? Support your answer with an analysis of how much more or less equity you would have to bring to the deal. Show your work.