What is the accepted approach with respect to underwriting to forecast a refinance on a multi family property. What interest rate should be assumed and on what basis.
How many units does the property have? Is this commercial or residential property?
Typically, rates are set and based on factors like purchase price, credit score, LTV, the property type. An underwriter doesn't determine the rate.
The prudent approach is to assume some slight increase in interest rates-- usually 5 to 10 bps per year. But with the Fed's monetary policy these days, they might go lower before they go higher.
Regardless, it's also prudent to assuming the new loan will be the lesser of three values (or two if it's a smaller- to mid-sized multi) based on: (1) Loan-to-Value % (LTV), (2) Debt Service Coverage Ratio (DSCR), or (3) Debt Yield (DY). The first two are the most common.
Let's say you plan on refinancing in year 4 of your proforma. You'll take the trailing-12-month Net Operating Income (NOI) and calculate the property's market value using an assumed cap rate. For example, a $100,000 NOI with a 10cap would be a value of $1,000,000.
Apply the loan-to-value % (LTV) to get your first market value. Let's assume 80%, so that's a loan of $800,000.
Next, let's assume the bank requires a 1.20 DSCR. Divide the NOI of $100,000 by 1.20 and you'll get $83,333.33. This is the maximum annual debt payment the property will support. You can then take that number and use a financial calculation to get the Present Value assuming the new loan's interest rate and amortization period. This will give you the second loan. (In this case, I assume a 5% interest rate and 30-year amortization and got a loan of $1,281,038).
Finally, the Debt Yield (DY) is simply the NOI divided by the debt amount. So if the bank says they have a minimum debt yield of 8%, you'll get a maximum loan of $1,250,000.
So the minimum of these three is the LTV approach of $800,000. Now this example isn't perfect because I used a 10cap at the start, but hopefully you get the idea.
At this point, you'll be paying off the balance of your acquisition loan with the new loan and will need to pay the up front fees for the new loan in cash, so don't forget those. The difference will be the cash-out.
Thank you very much for this. I understand and appreciate the information.
One follow up question, I understand any prepayment penalty will depend on the financing we choose on the deal. If it is a step down i am not having any challenges on my numbers. But with yield maintenance i cant seem to get down the equation to use to calculate the full costs of the refi. Any guidance you can provide would be most helpful.
I'm not sure all "yield maintenance" formulas are the same but here is how mine works in a simplified example:
$5% interest rate
30 year amortization
Balloon payoff at year 10
For simplicity, interest only payments
Formula = (Loan Balance) * (Years Remaining) * (Lost Interest Yield)
Where Lost Yield = (Mortgage Interest Rate) - (Treasury Interest Rate on payoff date)
If we paid this off in year 3, we would have 7 years remaining. Because this is interest only, the balance remains at $1,000,000. If the Treasury Yield on a 7-year note was 2%, then the lost interest yield is 3% (5%-2%). This gives the following:
Yield Maintenance = ($1,000,000) * (7 years) * (3% per year) = $210,000
The formula you see in the contract is done using months not years.
The hard part is predicting what the Treasury Yield will be in the future when you payoff early.
Oops, in my example their is no 30-year amortization as it was interest only payments!
@Michael M. Thanks for the breakdown, it's brilliant! Do you know if there are any Excel models that cover the prepayment penalties in full detail? I'm trying to model it on my analysis spreadsheet. Thanks in advance and sorry to hijack the thread!