Purchase Money with Subordinated Debt on Commercial Property

What is ‘Subordinated Debt‘? Subordinated Debt is a loan or security that ranks below other loans and securities with regard to claims on a company’s assets, their earnings or real property and in this case study, the real estate is the asset Subordinated debt is also known as a junior security, junior liens or subordinated loan.

Real estate debt is also classified as first and second liens or junior liens, but the junior liens are also “subordinated debt”. Why? Because it is subordinated to all other senior liens on the property.

By not understanding debt and how it affects all aspects of real estate, could be very costly to you, and your client. Ignoring debt and the effects it has on real estate, in many ways it could be as if you tied your hands or your client’s hands behind their back and threw them into the ocean or a pool and walked away.

What you don’t know or understand about debt can have long term ramifications not only to your client but to you as well.

Over the past few months I have been receiving more and more inquiries as to the acceptance of subordinated debt by institutional lenders and sellers when purchasing commercial real estate.

This is a common occurrence when the market begins to see the pressure it has experienced in the past 12 months. Cap rates are at an all time low, and financing has become more and more conservative with the advent of the regulators applying pressure to the banks on their underwriting criteria and their servicing portfolios.

Let’s look at how a bank would underwrite subordinate debt on a purchase of a commercial asset.

Assume a 10-unit apartment building – Sales Price of $1,025,000. GSI of $100,000. The potential buyer has $300,000 to use as a down payment and reserves. The buyer wants to put $250,000 down and have the seller carry a $100,000 second (subordinate debt). The second will be for a term of 5 years with an interest rate of 6.0%. The subordinated debt would be structured as an interest only loan to keep the payments as low as possible. Or a 30-year amortization all due and payable in 5 years. Still keeping the payment at a reasonable figure to justify purchasing the property. Many buyers, sellers and agents would consider this a good deal for all parties. Is it really a good deal for all parties?

But can you find a bank to lend $675,000 on this property, with this buyer and those terms?

The terms of the subordinate debt are important to the buyer and seller, but the lender has their own way to determine the final loan amount.

Scenario 1

  • Gross Scheduled Income – $100,000
  • Less Vacancy and Bad Debt (5.0%) – $5,000
  • Effective Gross Income – $95,000
  • Less Operating Expenses – $36,100 ($3,610 Per Unit)
  • Less Replacement Reserves – $3,800 ($ 380 Per Unit)
  • Net Operating Income – $55,100
  • Value Using a 5.38% Cap Rate – $1,025,000

Underwriting Loan Terms:

If we use a 5.0% start and qualifying rate for the first lien, the property would underwrite with a debt service coverage ratio of 1.27 and a loan amount of $675,000. The bank’s minimum DSCR is 1.25. Simple enough. But what about the subordinated debt?

How does a lender look at a property with subordinated debt? The bank’s primary concern is their loan secure? Wil the buyer be able to make the payments? How will we get paid off?

Debt Service:

  • 1st Lien of $675,000
  • Annual Payment Based on 5.0% – $43,483
  • DSCR 1.27
  • Subordinated Debt – $100,000
  • Interest Only Payments of 6.0% Annually – $6,000
  • Amortized Payments 30/5 Annually – $7,195

Combined Payments and its effect on the overall Debt Service Coverage Ratio (DSCR)

  • Interest Only Combined DSCR of 1.14
  • 30/5 Amortization Combined DSCR of 1.09

The combined DSCR falls below the threshold of the bank’s minimum DSCR of 1.25 creating a greater overall risk to their asset, which is their loan, not the property. If the bank were to allow the subordinated debt and the terms provided in this scenario, the bank would lower their loan amount and increase the subordinated debt until they were able to sustain a minimum DSCR of 1.25.

In Scenario 1, the paramount concern for all parties involved should be “How is the buyer going to retire the $100,000 subordinated debt in 5 years”?

Through appreciation? A loan on an investment property is not underwritten solely upon the loan to value. An increase in value provides the owners with additional equity but it will not provide the owner with a loan amount sufficient to retire the additional $100,000 in subordinate debt. The loan will be primarily based upon a debt service coverage ratio (DSCR) based upon the properties net operating income. In our scenario, the buyer started with an NOI of $55,100, sufficient to provide a loan in the amount of $675,000. For both loans to be paid off in 5 years, the property would have to underwrite with an NOI of $64,000, as long as underwriting guidelines remain the same and the interest rate stays at 5%, not likely. Over the past 10 to 15 years, the minimum DSCR’s have increased due to the 2008 real estate crash. Prior to 2008, investment property was underwritten with a DSCR as low as 1.10 -1.15. Today the minimum DSCR ranges from a low of 1.20-1.25 for multifamily and 1.30-1.35 for commercial property. The DSCR is the primary underwriting tool utilized by the bank to establish the loan amount and the loan to value is the secondary criteria.

Increase the Rents? Raise the rents, and reduce the expenses to obtain a higher NOI. As we stated in the previous paragraph, the underwriting guidelines as well as the current interest rates would have to remain the same and if the owner was able to increase the NOI to $64,000, the entire debt of $775,000 could be financed. Increased rents and lower expenses can only be revised after purchase and will not be used to calculate a better DSCR for the loan.

Based upon these two variables, as well as several other factors which affect the real estate market, lenders would not be willing to take risks based upon unknown factors. Lenders are never the first ones to a party.

How a Lender would review this loan request with subordinate debt.

Debt Service:

  • 1st Lien of $675,000
  • Annual Payment Based on 5.0% – $43,483
  • DSCR 1.27
  • Subordinated Debt – $100,000
  • Amortized over 5 Years (5 years due in 5 years) – $23,199

Combined Payments and its effect on the overall DSCR

Combined DSCR of .66 (less than breakeven 1.00)

In this scenario, the buyer would have a negative annual cash flow based upon the bank’s underwriting of $11,582 (NOI of $55,100 less debt payments of $66,682).