Mortgaging Projects Discussion Question

Mortgaging Projects Discussion Question

I’m working on a real estate multi-part question and need an explanation to help me learn.

In this course project, we return to the 5789 Project. Earlier, we established the project’s feasibility and evaluated two loans for the project, sizing the loan using an LTC Ratio, a DCR Ratio, and a Debt Yield. The two loans include:

A Base Case loan with twenty-year amortization and a 4.65% interest rate; using the three criteria, this loan was constrained by the DCR Ratio and sized to $15,875,057.
An Optional Terms loan with thirty-year amortization and a 4.75% interest rate; using the three criteria, this loan was constrained by the LTC Ratio and sized to $17,938,400.
The following table provides the specific details of the Base Case loan and Optional Terms loan for the 5789 Project.

5789 Project

Optional Terms Loan
50% LTC

Base Case Loan
44.25% LTC

Amount Borrowed

$17,938,400

$15,875,057

Interest Rate

4.75%

4.65%

Amortization

30 years

20 years

ECB

4.89%

4.76%

DCR in Year 3

2.51

2.31

RMB at End of Year 5

$16,413,320

$13,164,980

Project Cost

$35,876,800

$35,876,800

Net Sale Proceeds in Year 5

$41,490,258

$41,490,258

Overall Project IRR

10.16%

10.16%

Equity Required

$18,072,938

$20,120,806

Before-Tax Equity Reversion

$25,076,939

$28,325,279

Before-Tax IRR

14.63%

13.67%

After-Tax Equity Reversion

$23,606,023

$26,308,363

After-Tax IRR

11.34%

10.49%

In the end, the developer decided to use the Optional Terms loan, which produces higher equity IRR’s for the investor than the Base Case loan. However, the Optional Terms loan has a higher effective cost of borrowing (ECB) and a higher remaining balance, and thus produces lower before- and after-tax reversions than the Base Case loan.

Interestingly, due to the longer amortization term, the Optional Terms loan has a higher DCR than the Base Case loan, indicating lower risk of a default if the project does not perform as expected. In addition, the Optional Terms loan requires a lower equity investment, which could be positive or negative, depending on the investor’s capital constraints

Based on the information above, answer the following questions to complete this project:

Characterize the risks that the investor is taking under the Optional Terms financing scenario relative to the Base Case scenario.
Indicate whether you feel that the increased equity IRRs adequately compensate the investor for these risks.
In addition, indicate what other metrics or information you would need to complete your evaluation of the Optional Terms loan vs. the Base Case loan.
Requirements: a couple lines | .doc file