Debt Mark-to-Market
This article is part of a series covering basic components of a real estate PPA study.
When acquiring real estate, the existing mortgage debt is sometimes assumed from the Seller. Whenever debt is assumed, it must be included as part of the PPA, whether done under ASC 805 or as an asset acquisition. The logic is that the debt potentially has value to the new owner (e.g., favorable/below market) or is detrimental (e.g., unfavorable/above market).
Determine Market Terms
In this exercise, we compare the remaining debt obligation against a new hypothetical debt issuance at the same terms of the remaining payment period (as opposed to the original note terms). For example, if the note has three years P&L remaining, it doesn’t matter for our purposes that it may have originally been a ten-year loan with a one-year I/0 period. This can be a bit of a hypothetical exercise if the remaining term is not one that would normally be offered in the current market.
To research the debt terms for the subject debt situation, first determine the current loan Outstanding Balance, Interest Rate, Remaining Term, LTV, DSCR, guarantor requirements, and model out the monthly payments, including any balloon payment at the end of term, or any pre-payment penalties if early payoff is more advantageous.
Research market interest rates for a new debt instrument with similar characteristics to the subject. The market interest rate is sometimes easily pegged to advertised rates, but other times is best built up by staring with a Prime or Libor rate and then adding spreads and risk factor adjustments consistent with lender requirements.
Adjust for remaining term
If you have four years remaining term but can only find rates for seven year term debt, it will be necessary to adjust for the shorter term. This can be done by comparing US Treasury rate spreads between the seven year, five year, and three year terms, and extrapolating to conclude a reasonable assumption for your four year term. For instance, the difference in rate can be determined between each time period and then applied as an adjustment to your market rate reference point (e.g., if you have an interest rate quote for a 7-year term but your subject has 5 years remaining, you can calculate the number of basis points difference between the US Treasury 7-year and 5-year notes and apply that difference to your quoted rate).
Adjust for guarantor obligations
This one can be tricky, but see if you can discuss with your lender or mortgage broker the rate impact of different guarantor obligations.
Adjust for LTV and DSCR
By researching various debt offerings, you will build a sense of the rate spreads between different loan-to-value (LTV) and debt service coverage ratio (DSCR) thresholds. While not an exact science, it is important to take these factors into consideration. Many times, LTV has less to do with rate directly and just dictates which loan offerings the property would be eligible for (several Fannie Mae and Freddie Mac programs have strict LTV and DSCR requirements). Generally speaking, the market rate should be based on the best loan program the property would currently qualify for regardless of whether or not the same product was available at original issuance of the debt instrument you are marking to market.
Calculate the Difference between contract and market
Build out a monthly debt repayment schedule for the remaining contract term, showing all expected payments over the life of the loan. Next, calculate the net present value (NPV) of that payment schedule using the concluded market interest rate as the discount rate. The resulting value is the fair market value of the debt instrument at today’s debt terms. Compare this result to the outstanding balance of the note. If the two values differ more than your reporting tolerance, consider reporting an intangible asset or liability.