Case 035Project and real asset financeCore

A business park is valued at an 8% cap rate with a 65% loan-to-value covenant. Rates rise and the cap rate moves to 9.5%. What happens to value and LTV, what paydown cures the breach, and what if rents fall too?

MSCIMumbai · 2015

The situation

Tarvani Business Park is an office campus let to technology tenants on long leases. It earns net operating income (NOI), rent less the landlord's running costs, of Rs 72 crore a year. The bank values it at an 8% capitalisation rate, NOI divided by the yield buyers demand, so it is worth Rs 900 crore.

The bank has lent Rs 540 crore against it, with a covenant that the loan must not exceed 65% of the property's value. Interest rates rise and comparable sales now point to a cap rate of 9.5%.

Your task

What is the new value and LTV, how much must the owner repay to cure the covenant, and what happens if rents also fall 10%?

Quick check

At a 9.5% cap rate, roughly where does the loan-to-value land?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

At a 9.5% cap rate the park is worth about Rs 758 crore and the LTV rises from 60% to 71.2%, a breach. Curing it needs a paydown of about Rs 47 crore. If rents also fall 10%, value drops to about Rs 682 crore, LTV reaches 79.2% and the cure needs about Rs 97 crore. Nothing about the tenants changed in the first case; the rate rise alone moved the value.

Step 1Why does a rate rise hit the value directly?

A shop that earns Rs 1 lakh a year in rent is worth what someone will pay for that income. If buyers want an 8% yield they pay Rs 12.5 lakh; if bank deposits start paying more and they want 9.5%, they pay only about Rs 10.5 lakh for the same rent. Value is NOI divided by the cap rateCapitalisation rate: the yearly net operating income of a property divided by its value. It moves with interest rates and with how risky buyers think the income is., so when the cap rate rises and income stays put, value falls. For Tarvani, Rs 72 crore over 9.5% is Rs 757.9 crore, down 15.8% from Rs 900 crore.

Step 2How far does the LTV move, and what cures it?

The loan stays at Rs 540 crore while the value under it shrinks. LTV goes from 540 over 900, 60%, to 540 over 757.9, 71.2%. The covenant allows 65% of Rs 757.9 crore, Rs 492.6 crore, so the owner must repay about Rs 47.4 crore or post equivalent extra security. Work the breach point backwards: the covenant holds while value is at least 540 over 0.65, Rs 830.8 crore, which with full rents means a cap rate up to 8.67%. A move of only about 67 basis points was enough to breach.

Value falls as the cap rate rises; the covenant line does not move6008001,0001,2006%7%8%9%10%11%Cap rate: the yield buyers demand on net operating incomeValue, Rs crorecovenant: value at least 831breach zone8%: 900, LTV 60%9.5%: 758, LTV 71.2%rents -10%: 682, LTV 79.2%breach begins at 8.67%NOI Rs 72 croreNOI Rs 64.8 crore, rents -10%
Tarvani's value falls from Rs 900 crore at an 8% cap rate to Rs 758 crore at 9.5%, below the Rs 831 crore the covenant needs; with rents 10% lower it falls to Rs 682 crore, and the covenant would already be breached at a cap rate of 7.8%.
Step 3What happens when rents fall at the same time?

Rate rises often arrive with slower growth, and tenants renegotiate. With NOI down 10% to Rs 64.8 crore and a 9.5% cap rate, value is Rs 682.1 crore, LTV is 79.2% and the cure needs about Rs 97 crore, about twice the rate-only case. The paydown doubles because the cap rate move had already used up the covenant cushion, so every rupee of value lost to lower rents goes straight into the cure, at 65 paise of loan per rupee. Treat a 10% fall in NOI as a simplification: when running costs are fixed, NOI falls faster than rent.

ScenarioNOICap rateValueLTVPaydown to cure
Today72.08.0%900.060.0%none
Rates rise72.09.5%757.971.2%47.4
Rates rise and rents fall 10%64.89.5%682.179.2%96.6
Rs crore. On a fixed Rs 540 crore loan, a 150 basis point rise in the cap rate lifts LTV to 71.2% and needs a Rs 47 crore paydown; adding a 10% fall in NOI lifts it to 79.2% and the paydown to Rs 97 crore.
Step 4What would you do as the lender?

First, check how value is tested: an appraisal once a year, or a mark whenever the market moves. Cap rates are opinions until a sale happens, and an owner will dispute a 9.5% mark. Second, look at the cash covenant, interest cover or debt service cover, because a property can breach LTV while still paying its interest comfortably. Then agree a cure period and a paydown plan rather than accelerating the loan, since a forced sale in a rising-rate market would realise the low value the covenant was written to avoid.

Where candidates lose it

The common slip is to say nothing has changed because rents and tenants are the same. In real estate, value is income divided by a yield, and the yield moved.

The second is to test only the rate shock. Rents rarely hold still when rates rise, and a 10% fall in NOI on top doubles the paydown from about Rs 47 crore to Rs 97 crore, because the cap rate move had already used up the covenant's cushion.

What the interviewer asks next

  • What cap rate would breach the covenant if rents had risen 5% instead?
  • Why might the bank prefer an interest cover covenant to an LTV covenant on this loan?
  • How would a lender stress a portfolio of fifty such loans?

Asked at MSCI, Real Estate, Mumbai, 2015 (Wall Street Oasis): What if questions like effect of interest rate, GDP, inflation on stock prices. Valuation methods for real estate investments.

Company names and figures are illustrative.