Cap rates for income-producing properties have fallen to 5% or below in many primary markets, including New York, Los Angeles and San Francisco. As a result, borrowers seeking 75% Loan-to-Value (LTV) loans are finding that loan proceeds are constrained below 75% because the property cash flow does not meet the minimum debt-service coverage ratio (DCSR) of 1.25x when applied to the full 75% loan amount. Therefore, borrowers are forced to invest more equity than desired for a purchase or receive less cash-out proceeds from a refinance.
Fortunately, a solution exists when a CMBS conduit loan is the source of financing. CMBS conduit loans allow for interest-only (IO) payment periods before the loan begins to amortize. Typically, IO periods are 36 months (3 years) or 60 months (5 years). After the IO period ends, the loan payments begin to amortize on a 30-year repayment schedule. The good news is that the interest-only payments will be used to calculate DSCR, enabling the borrower to reach full 75% loan proceeds with cap rates as low as 75%.
Give it a try yourself: Take a hypothetical property in a primary market with $100,000 of net cash flow and assume you want to buy the property at a 5% cap rate, or $2 million. At a 5% interest rate and a $1.5-million loan, interest-only debt service is $75,000 a year and DSCR is 1.33x ($100,000/$75,000). If the loan was structured to amortize on a 30-year schedule, debt service would be $96,000 per year and DSCR would be roughly 1.05x, which is well below the 1.25x standard. Therefore, the loan proceeds would have to be reduced to a level that supports a 1.25x DSCR, which is roughly at a 65% LTV. So you can see how a CMBS conduit loan with an IO feature can solve the problem!