Four Pillars of a Quality Mortgage

Real estate investing without mortgage financing is a foreign concept to most American investors. While cash purchases do occur, they represent only a fraction of the trade.

Real estate finance can be a complicated mistress.  We tolerate all types of madness for the sake of getting the deal done from personal guarantees to excess reserve accounts.  At the end of the day, all we want is a loan that works, a loan that fits our investment style and a loan that fits the deal.  A loan that allows for undisturbed sleep at night.  How hard can that be?

In the evolution of mortgage financing, lenders have expanded the boundaries to include a rainbow of options.  The recent recession has decreased the colors in this rainbow, but we still have five hundred more options today than our grandparents.  Ok, may that’s a bit of a stretch, but only a little. 

At their peak, mortgage lenders were creating more products that Detroit has cars.  The options have decreased, yes, but remember, the objective of  the mortgage lender is to produce a delivered return to their shareholders. 

If we were building our very own mortgage loan what would that look like?  In the real world, no zero interest, self-liquidating options.  Here are the four things I would want in every mortgage.  The “wish list” items are all beneficial to the borrower. 

Reasonable leverage.  A lenders willingness to provide a 75-80% loan-to-value mortgage is separate and distinct from the borrowers decision to leverage to that level.  What is the appropriate leverage given the goals and objectives of the property owner?  Maximizing IRR (Internal Rate of Return) is the presumed objective, but presumption is a very bad word to hang your hat on when dealing with real dollars where investor objectives can be focused on something other than long-term IRR. 

Wish list item:  1.50 (DSC) debt service coverage. (where annual Net Operating Income equals 150% of annual mortgage payments) 

Leverage is often a function of risk appetite.  Yes, yields can increase substantially with increased leverage, but  so does potential loss of equity.   There are a multitude of variables that impact getting to a 1.50 DSC; purchase price, cash in, etc.  Big variables.  Just note that obtaining “peaceful sleep” is much easier with greater DSC.

Fixed Rate Financing. Variable rate mortgages are used predominantly to allow deals to work in varying interest rate environments.  Rates that float invariably increase.  It’s a timing game. 

Wish list item: A fixed rate that is actually “fixed” for the entire amortized term of the mortgage. 

Long-term Amortization.  A 30-year commercial mortgage is hard to come by these days.  Granted, the amortization schedule is often based on a  30 year term, but the actual term of the loan is invariably shorter.  This is one reason why loans from GSE’s (Government Sponsored Entities) have become so popular as they continue to offer an actual 30 year term.  

Wish list item: No pre-payment penalties allowed under any circumstances. 

The longer the term of the mortgage, the greater the flexibility.   We can shorten the amortization by increasing monthly payments towards principal (although this is seldom done).  However, many CMBS loans forbid principal reductions. 

Wish list: A long-term mortgage with no restrictions to principal reduction payments (mortgage pay down) and no pre-payment penalties. 

Accurate Assessment of Cap Ex.  Projecting capital expenditures pre-acquisition is of great use and comfort to long-term owners.  While we cannot plan for every contingency, it is imperative (and progressive) to plan for known capital expenditures. 

Wish list item:  A capital assessment that is absolutely real, accomplished by an un-biased professional, one who owns no rose colored glasses.  An assessment by an honest actor. 

 The borrower has significant input in to each of these four categories.  Terms offered by the lender in the first three categories are a function of cash, credit and asset quality.  For the sake of comfort in knowing the real costs associated with  long-term ownership it is important to have a professional cap ex assessment.

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Multifamily Insight is dedicated to assisting current and future multifamily property owners, operators and investors in executing specific tasks that allow multifamily assets to operate at their highest level of efficiency. We discuss real world issues in multifamily property management and acquisitions. This blog is intended to be informational only and does not provide legal, financial or accounting advice. Seek professional counsel.  For more information, visit:

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