Running Head: THE TROUBLE WITH LENDERS: SUBTLETIES IN THE DEBT
FINANCING OF COMMERCIAL REAL ESTATE
The Trouble with Lenders: Subtleties in the Debt Financing of Commercial Real Estate
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Table of Contents
Problem Diagnosis...........................................................................................................................2
Analysis...........................................................................................................................................3
Current Performance of Cirano Properties...................................................................................4
Evaluation of Financing Alternatives for Brookline Road Shopping Center..............................5
Evaluation of Financing Alternatives for Columbus Festival Plaza Property.............................8
Recommendations for Brookline Road Shopping Center and Columbus Festival Plaza Properties
.......................................................................................................................................................10
References......................................................................................................................................11
The Trouble with Lenders: Subtleties in the
Debt Financing of Commercial Real Estate
Problem Diagnosis
The interest rates in 2015 have been at an all-time low and Stanley Cirano was
considering to take advantage of this opportunity and reconsider the financing of the two core
properties in his commercial real estate portfolio. Cirano properties was the general manager on
two properties with the private equity investments in the suburb of Chicago. The first property is
the Brookline Road Shopping Center that he had acquired in 2006 and he has successfully
managed it through the real estate downturn and the financial crisis of 2008 (Furfine, 2016).
The performance of this property was good and Cirano was considering that whether he
should refinance this property or sell it now to take advantage of the higher revenues and the net
operating income. The second property in which, Cirano had invested is the Columbus Festival
Plaza and this was acquired in 2010 in a bankruptcy auction when Cirano’s bid had been the
lowest of all the bids. This property was also generating a good amount of the net operating
income, however, it required a good amount of the capital improvements since its acquisition in
2010 (Furfine, 2016).
Each of these two properties represented different management issue and their
performance had also been different with different rent roll patterns, however, there were also
many common factors in both the properties. For instance, both the properties were financing in
part by debt and since the first property was acquired in 2006 and the second property was
acquired in 2010, therefore, Cirano has chosen the most attractive financing options at of that
time and chose debt financing that provided him with the lowest interest costs (Furfine, 2016).
The central problem for Cirano now is to decide that whether he should refinance the
debt portion of both the properties or he should sell the properties now to take advantage of the
higher revenues and the net operating income. There are different debt financing alternatives
available for each of the two properties, therefore, we would be analyzed all the financing
alternatives for the two properties an also determine the valuation of both the properties based on
an assumed holding period. Each of the debt financing alternatives has a fixed schedule and
minimum required debt service coverage ratio (DSCR). Therefore, final recommendations would
be made after analyzing all of these issues in detail.
Analysis
We begin our analysis by discussing the current performance of both the properties and
then, we proceed with the further analysis.
Current Performance of Cirano Properties
The first property is the Brookline Road Shopping Center that he had acquired in 2006
and he has successfully managed it through the real estate downturn and the financial crisis of
2008. This is a newly constructed property and the location of the property is also highly
attractive between the Brookline and Mundee roads. The NOI of the property has significantly
grown from $ 754,000 to $ 900,000 between 2006 and 2015.
The leasing of the property to Chipotle was the major factor in the huge income growth
of the property and the property has performed well and came out of the 2008 financial crisis.
The real estate investors of the property now had mixed views about the future plans of the
property as some of them wanted Cirano to sell the property and generate huge sales proceeds
while others wanted to wait for the most opportune time to sell the property at a much higher
price.
The second property in which, Cirano had invested is the Columbus Festival Plaza and
this was acquired in 2010 in a bankruptcy auction when Cirano’s bid had been the lowest of all
the bids. This property was a bit old but still in a good condition and at a favorable location in at
the corner of the Crawford and Columbus. The traffic visibility around this property was also
high.
This property also currently had some vacant space currently and Cirano was sure that
once the economy improved, he would be able to fill that space up. The net operating income for
this property has also increased from $ 765,000 to $ 1 million between 2010 and 2015. The huge
growth in the operating income of the property was observed after the lease signing with the
CVS Pharmacy. Therefore, the future prospects of this property also seem to be favorable.
Evaluation of Financing Alternatives for Brookline Road Shopping Center
We now evaluate the three financing alternatives that are stated in the case for
refinancing the Brookline Road Shopping Center property. We have first calculated the average
value of the Brookline Road Shopping Center property based on the information of the
comparable properties that is provided in case exhibit 7. There are three comparable properties
shown and all of them match the characteristics of the Brookline Road Shopping Center in terms
of their size.
We have averaged their values to compute the average value for Brookline Shopping
Center property (Barris, 2008). This is shown in the table below:
Brookline Road Shopping Center Valuation
Property Price
Copley Center 10,600,000
Remington Plaza 6,896,000
Golf view Center 4,000,000
Value of Brookline Road Shopping Center 7,165,333
For the further analysis, we have used the respective terms of each financing loan options
to calculate the amount of the loan, interest costs, principle payments, total debt servicing and
debt coverage ratios. We have also forecasted the net operating income and the net operating
cash flow for this property for the next 5 years assuming that after refinancing, it would be heold
for 5 years only. Historical average growth percentages for NOI and net operating cash flows
along with capital costs as a percentage of NOI have been used to do this.
Finally, we have performed the valuation for this property using the cap rate given in
exhibit 8 of the case. The relevant cap rate has been selected to be 8.27% based on the 65611 sq.
foot size of this property (Isaac, 2012). The analysis of each of the three financing options
available to Cirano for this property is as follows:
Skyline Bank Loan (Alternative 1)
The first debt financing option is provided by the Skyline bank which has also provided
the initial debt financing for this property and has just 3 months left to its maturity. The mortgage
loan amortization schedule for this loan has been generated in the excel spreadsheet based on an
amortization schedule of 30 years, with a LTV ratio of 65% and the interest costs of 4.38%. The
total amount of the mortgage loan that would be made by the lender under this option would be $
4,657,466 as calculated in the excel spreadsheet.
The debt service costs in each year would be $ 281,739. Based on these, we have
calculated the debt service coverage ratio for each of the five forecasted years, which give us an
average DSCR of 3.43. The minimum DSCR required for this loan is 1.25. Furthermore, the
value of the property based on this loan’s refinancing would be $ 7.34 million and this gives
Cirano a capital gain of 2.48%, assuming that the property would be sold by the end of the 5th
year.
Fourth Second Bank Loan (Alternative 2)
The second debt financing option is provided by the Fourth Second bank. The mortgage
loan amortization schedule for this loan has been generated in the excel spreadsheet based on an
amortization schedule of 25 years, with a LTV ratio of 60% and the interest costs of 3.63%. The
total amount of the mortgage loan that would be made by the lender under this option would be $
4,299,200 as calculated in the excel spreadsheet.
The debt service costs in each year would be $ 264,401. Based on these, we have
calculated the debt service coverage ratio for each of the five forecasted years, which give us an
average DSCR of 3.65. The minimum DSCR required for this loan is 1.30. Furthermore, the
value of the property based on this loan’s refinancing would be $ 7.55 million and this gives
Cirano a capital gain of 5.41%, assuming that the property would be sold by the end of 5th year.
Regional Liberty Loan (Alternative 3)
The third debt financing option is provided by the Regional Property Bank. The mortgage
loan amortization schedule for this loan has been generated in the excel spreadsheet based on an
amortization schedule of 30 years, with a LTV ratio of 70% and the interest costs of 4.63%. The
total amount of the mortgage loan that would be made by the lender under this option would be $
5,015,733 as calculated in the excel spreadsheet.
The debt service costs in each year would be $ 312,467. Based on these, we have
calculated the debt service coverage ratio for each of the five forecasted years, which give us an
average DSCR of 3.00. The minimum DSCR required for this loan is 1.20. Furthermore, the
value of the property based on this loan’s refinancing would be $ 6.97 million and this gives
Cirano a capital gain of -2.70%, assuming that the property would be sold by the end of 5th year.
Evaluation of Financing Alternatives for Columbus Festival Plaza Property
We have then evaluated the two financing alternatives that are stated in the case for
refinancing the Columbus Festival Plaza Property. We have first calculated the average value of
the Columbus Festival Plaza Property based on the information of the comparable properties that
is provided in case exhibit 7. There are four comparable properties shown and all of them match
the characteristics of the Columbus Festival Plaza Property in terms of their size except Fox Run
Square because of its excessively large size so this has been excluded.
We have averaged their values to compute the average value for Columbus Festival Plaza
Property (Barris, 2008). This is shown in the table below:
Columbus Festival Plaza Valuation
Property Price
Fox Run Square Excluded due to high size
363 N Weber Rd 6,400,000
The Landings 9,500,000
Prairie Point SC 18,151,363
Value of Brookline Road Shopping Center 11,350,454
For the further analysis, we have used the respective terms of each financing loan options
to calculate the amount of the loan, interest costs, principle payments, total debt servicing and
debt coverage ratios. We have also forecasted the net operating income and the net operating
cash flow for this property for the next 5 years assuming that after refinancing, it would be heold
for 5 years only. Historical average growth percentages for NOI and net operating cash flows
along with capital costs as a percentage of NOI have been used to do this just like we did for the
first property (Maliene, 2011).
Finally, we have performed the valuation for this property using the cap rate given in
exhibit 8 of the case. The relevant cap rate has been selected to be 7.79% based on the 113,572
sq. foot size of this property. The analysis of each of the two financing options available to
Cirano for this property is as follows:
Oakwood Commercial Loan (Alternative 1)
The first debt financing option is provided by the Oakwood Commercial Bank. The
mortgage loan amortization schedule for this loan has been generated in the excel spreadsheet
based on an amortization schedule of 25 years, with a LTV ratio of 65% and the interest costs of
4.90%. The total amount of the mortgage loan that would be made by the lender under this
option would be $ 7,377,795 as calculated in the excel spreadsheet.
The debt service costs in each year would be $ 518,238. Based on these, we have
calculated the debt service coverage ratio for each of the five forecasted years, which give us an
average DSCR of 2.44. The minimum DSCR required for this loan is 1.25. Furthermore, the
value of the property based on this loan’s refinancing would be $ 9.36 million and this gives
Cirano a capital gain of -17.52%, assuming that the property would be sold by the end of 5th year.
Northwood National Loan (Alternative 2)
The second debt financing option is provided by the Northwood National Bank. The
mortgage loan amortization schedule for this loan has been generated in the excel spreadsheet
based on an amortization schedule of 30 years, with a LTV ratio of 60% and the interest costs of
4.13%. The total amount of the mortgage loan that would be made by the lender under this
option would be $ 6,810,272 as calculated in the excel spreadsheet.
The debt service costs in each year would be $ 399,838. Based on these, we have
calculated the debt service coverage ratio for each of the five forecasted years, which give us an
average DSCR of 3.17. The minimum DSCR required for this loan is 1.40. Furthermore, the
value of the property based on this loan’s refinancing would be $ 10.88 million and this gives
Cirano a capital gain of -14.12%, assuming that the property would be sold by the end of 5th year.
Recommendations for Brookline Road Shopping Center and Columbus
Festival Plaza Properties
The detailed qualitative and quantitative analysis has been performed for both the
properties. For the first property which is Brookline Road Shopping Center, the current
performance is highly strong and its current loan with Skyline Bank would end in three months.
Furthermore, the analysis of the three loan options shows that the property would be able to
maintain and sustain higher NOI in the future years and it would also be able to maintain higher
DSCR than the minimum DSCR required under each of the three loan options. The capital gain,
however, under the second loan option, is the highest of all, which is 5.41%, therefore, Cirano is
recommended to refinance the property and take the loan offer from Fourth Second Bank.
For the second property which is Columbus Shopping Center, the current performance is
also highly strong and its current loan would also end soon. Furthermore, the analysis of the two
loan options shows that the property would be able to maintain and sustain higher NOI in the
future years and it would also be able to maintain higher DSCR than the minimum DSCR
required under each of the two loan options. However, the issue is that the capital gain with both
the loans is negative and Cirano would not be able to generate any value by holding the
properties and refinancing them, therefore, Cirano is recommended to sell this property now and
take advantage of the higher sales proceeds and invest the proceeds in any other commercial
property.
References
Barris. (2008). An expert system for appraisal by the method of comparison. PhD Thesis, UPC,
Barcelona.
Furfine, C. (2016). The Trouble with Lenders: Subtleties in the Debt Financing of Commercial
Real Estate. Kellogg Case Publishing.
Isaac. (2012). Property Valuation Principles. Palgrave MacMillan, London.
Maliene. (2011). Specialised property valuation: Multiple criteria decision analysis. Journal of
Retail & Leisure Property.
