New on FinoLib · Volume III: Finance Encyclopedia
I have added a new article to FinoLib, my finance education website: Project Finance and Commercial Real Estate Debt (CMBS), part of Volume III: Finance Encyclopedia. This page gives you the core of the topic in expert but plain language; the full article goes much deeper.
2.4 Commercial Real Estate Debt — Mortgages, CMBS, and Mezzanine
The idea in plain words
Commercial property loans are limited by the smallest of three tests: loan-to-value, debt service coverage and debt yield. Many are pooled into CMBS, bonds backed by those loans, where losses run from the bottom layer, the B-piece, upward, and a special servicer takes over defaults. Mezzanine loans sit behind the main loan and are secured by the ownership interests, not the building.
Key points
■At low rates value limits the loan; at high rates cash flow does ($80.0M vs $78.2M in the worked example).
■Debt yield (NOI ÷ loan) ignores interest rates and cap rates, so cheap money cannot inflate it.
■Refinancing at maturity is the main danger: a building with unchanged NOI can need $27.5M of new equity.
A closer look
Senior debt on a commercial property is typically originated as a commercial mortgage, secured directly against the building. Many such mortgages are subsequently pooled together and sold to investors as Commercial Mortgage-Backed Securities (CMBS) — the commercial real estate equivalent of the residential mortgage securitization covered in Volume I’s Part 11, tranched by seniority in the same waterfall structure. Mezzanine debt, sitting between senior debt and equity in the capital stack, is typically secured not against the property directly but against the equity ownership interests in the entity that owns the property — a legally distinct structure that allows it to be subordinated cleanly to the senior mortgage.
Decision rule
Size to the smallest of the LTV, DSCR and debt-yield answers, then stress the maturity: interest rate +2 points, cap rate +1 point. If the loan you could then refinance is smaller than the balance due, borrow less now or reserve the equity to fill the gap. A debt yield under about 8–9% at maturity signals dependence on cheap credit (a heuristic). For construction loans there is no NOI yet; use loan-to-cost and completion guarantees.
The costliest mistake
Assuming a maturing loan will refinance at its balance. A 2021 buyer pays $145.5M for the $8.00M-NOI building (5.5% cap rate) with a 70% interest-only loan of $101.8M at an illustrative 3.5% (DSCR 2.24×, debt yield 7.9%). At maturity, cap rate 7.0% and loan rate 7.25%: value $114.3M; new loan = smallest of 65% LTV ($74.3M), 1.25× DSCR ($78.2M) and 9% debt yield ($88.9M) = $74.3M. The owner needs $27.5M of new equity or loses the building, with NOI unchanged. The 7.9% debt yield was the warning.
2.5 Project Finance — The Infrastructure Financing Model
The idea in plain words
Project finance funds a single asset, such as a power plant, through a special company whose debt is repaid only from the project’s own cash flow. Lenders work out how much to lend from the cash available to pay debt, using a minimum debt service coverage ratio, and check the whole life of the loan with the LLCR. They protect themselves with a cash waterfall, a debt service reserve and a web of contracts.
Key points
■$30M of CFADS for 15 years at 6% and 1.30× supports $224.1M of debt.
■When a P90 case at 1.20× binds, the same plant supports only $210.4M.
■In the worked example, a six-month DSRA covers two years of CFADS 13% below debt service without a payment default.
Decision rule
Size project debt on a downside case, such as P90 output for a solar or wind plant (the level exceeded with 90% probability) or low-case traffic for a toll road. If the downside LLCR is below about 1.10×, add equity, lengthen the tenor or strengthen the contract. Illustrative minimum DSCRs rise with revenue risk: about 1.20–1.30× for availability payments from a creditworthy government, 1.40× or more for traffic or market-price revenue. These are heuristics; each lender sets its own.
The costliest mistake
Sizing on the base case and calling it safe because it is “non-recourse”. Size at 1.30× on $30M of expected CFADS, then let actual CFADS run 20% lower at $24M: DSCR = $24M ÷ $23.08M = 1.04×. The project never defaults, but it sits below a 1.20× lock-up every year, so equity receives nothing for 15 years. Size on the downside case and check the lock-up against it.
Recap
Project finance lends to a single-asset SPV against its own cash flow: debt is sized from CFADS at a minimum DSCR on a downside case, the LLCR checks repayment over the loan’s whole life, and a cash waterfall, a debt service reserve and lock-up tests protect lenders.
What the full article covers
In the full article I take you through these sections:
■2.4 Commercial Real Estate Debt — Mortgages, CMBS, and Mezzanine
■2.5 Project Finance — The Infrastructure Financing Model
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, Project Finance and Commercial Real Estate Debt (CMBS), with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance