Maximizing the Loan Ratio

Josh,

This is very interesting topic and quite appropriate for this course, so thanks for bringing it up. I’ll go through your questions one-by-one.

1. How do you guys go about maximizing your LTV or LTC ratio?

Really, at a certain point the max leverage you can get is largely out of your hands. How much leverage you can get is a function of the property and the borrower. At the point when you go out to market for debt, the max leverage really has already been set by the market, based on the type of property/tenant securing the loan and who the borrower is.

So to max leverage (without changing the property or borrower), its best to go to as many lenders as possible. The wider a net you cast, the more debt options available to you. Most firms accomplish this by using a capital markets advisor (i.e. mortgage broker), or sourcing multiple lending sources themselves. This creates competition between lenders, which in turn pushes lenders to get more aggressive on loan proceeds.

2. In your experience, is it significantly more risky?

Yes. The more leverage you employ, the riskier the deal becomes. So while the upside increases with leverage, so does the downside. I’ve put together a quick-and-dirty model to illustrate my point. (Click here to download the Excel file)

I created four scenarios. A base case with and without high leverage, and a downside case, with and without leverage. You’ll see that when a deal has downside, and it happens in the real world more often than you think, the more leverage that has been employed the closer a deal gets to failing.

1) The base scenario states: 2.0% NOI growth, 65% LTV loan, amortizing loan over 30 years, with no shock to NOI during the term.

– The resulting unlevered IRR is 6.82%, levered IRR is 9.24%

2) The base scenario with high leverage states: 2.0% NOI growth, 80% LTV loan, amortizing loan over 30 years, with no shock to NOI during the term.

– The resulting unlevered IRR is 6.82%, levered IRR is 13.60%

3) The downside scenario states: 0% NOI growth and a 10% reduction in NOI, 60% LTV loan, and interest-only.

– The resulting unlevered IRR is 3.46%, levered IRR is 1.08%

4) The downside scenario with high leverage states: 0% NOI growth and a 10% reduction in NOI, 80% LTV loan, and interest-only.

– The resulting unlevered IRR is 3.46%, levered IRR is -5.29%

And in the downside scenario with high leverage (#4), the LTV at maturity (year 10) is 97%, which means the borrower won’t be able to refinance the loan and thus it will lose both the property and the $2 million in equity invested in the property.

This is why open-end core funds and REITs use low leverage (30 – 40% max across the portfolio). If principal preservation is at all important, maxing out leverage can have devastating consequences; both to the borrower’s balance sheet as well as to their reputation.

3. And lastly, do you know of anyone who has gotten a deal/development close to 100% LTV or LTC? And how did that deal play out?

Loans on properties leased to investment grade, single-tenants will often get close to 100% LTV. Because the debt service is effectively an investment-grade bond due to the credit of the tenant and thus the lender deems the income safe, the lender will offer proceeds up to the point where debt service coverage is just shy of 1.00X. In low interest rate environments with relatively low debt service payments, LTVs in these cases can approach 100%.

Also, while not 100% LTV, many borrowers have $0 equity in a property. This occurs when the property increases in value such that the loan amount exceeds the initial cost to the borrower. This might occur on a development deal, where significant value was created to the point where the borrower pulls all of its equity out of an investment. Or more commonly, where a borrower has owned the property for a long time to the point where the loan amount on a refinance exceeds the initial cost to the borrower.