04. Review Questions - Solutions

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Corporate Finance Institute ® Rocky Mountain Holdings Case Study Review Questions Solution

Corporate Finance Institute® Advance your career www.corporatefinanceinstitute.com Case Review Questions 1. Why might a lender be willing to prepare indicative financing terms for a commercial mortgage if no environmental report has been completed on the subject property? How does this differ from a formal approval request? The best way to arrive at the most accurate possible indicative terms is to have complete information – but that’s very rarely the case because of competitive pressures, and the nature of real estate transactions, which have multiple chicken and egg issues inherent within them. The reality is that indicative terms are only produced for the purpose of generating discussion with the client or prospect – as long as a clear expectation is set that a clean ESA will be required prior to a formal approval, there’s no harm in evaluating the other merits of a proposed transaction. Should that clean report not materialize, then you simply wouldn’t move ahead with a formal approval request. It’s exceedingly rare that a deal would be approved, conditional upon receipt of a clean ESA, but there are circumstances where that may occur... Receipt of the report would be a very clearly-stipulated condition of disbursement though. It’s worth noting that different institutions may have policies around indicative terms; and individual account managers and analysts may have different views on producing discussion papers. Some won’t go ahead without collecting an application or a due diligence fee of some kind since, as we illustrated in our case here, it can take a lot of time to arrive at indicative terms. Many banking professionals have been burned in the past spending time and resources conducting preliminary diligence on a deal, only to see it fall through because of environmental concerns. In general, requesting a non- refundable fee up front – perhaps a portion of the eventual projected closing fee – is a good policy. Then only clients or prospects who are very serious will actually put up cash to get the process moving... It helps to weed out deals where there’s a lack of conviction by the prospective buyer. 2. From a strategic standpoint, why is it important for Relationship Managers and Credit Analysts to be able to quickly and effectively produce discussion papers in the absence of complete information about a potential transaction? Competitive pressures have made it extremely important to be able to produce realistic and competitive terms for a proposed transaction in the absence of complete information. If you think about all the agreements, reports, and individual stakeholders that require alignment in a deal prior to having what would be considered “complete information”, by the time you had the info, there are likely another half-dozen lenders

Corporate Finance Institute® Advance your career www.corporatefinanceinstitute.com or financiers already looking at the transaction, and it could be too late for you to win the relationship. This early discovery period is a key part of the client negotiation process, because it allows you to build trust and demonstrate credibility from the first interaction. If you can show that you understand the transaction – even though some dots may still need to be connected – then you can help guide your client through the process and manage their expectations about timelines and structure. It’s very hard to win trust late in the process, it has to start early, with good advice and guidance. There’s an important caveat here though – most borrowers will agree that there’s nothing worse than a long “no”. If, in your early diligence you diagnose some elements that are likely to be deal breakers – perhaps because of risk appetite or specific policies at your firm – then you’re best to let the client down softly and early. Dragging the process on and asking for more documents and reports, costing them more money and time, only to ultimately arrive at what was likely already going to be a ‘no’ anyhow, will absolutely damage stakeholder relationships. 3. When working through your commercial mortgage model, why is it ok to arrive at an estimate of value that is lower than the appraised value? What variables potentially account for these differences? It’s very common for a commercial mortgage lender’s model to produce a lower estimate of value than a commercial real estate appraiser might. Remember, lenders go to great lengths to mitigate downside risk; one strategy to support this is rigorous sensitivity analysis. For some background, we highly encourage you to take CFI’s Commercial Mortgages course to better understand what that end-to-end process looks like. A property’s actual value is its market clearing price – characterized by the dollar amount where supply and demand meet. The appraised value is designed to be an objective assessment of what the property should be worth, based on current market conditions. Market forces are always nudging property values in one direction or another, and many market participants have incentive to see values climb, even if just slightly, year over year. Lenders on the other hand, try not to be swept up in current market trends – because if the bottom falls out of a market, their collateral will very quickly decrease in value. Lenders will frequently use more normal-looking data and variables (by historical standards) to run through their models. Virtually all these variables flow through to value estimates that are more conservative than current market conditions would suggest. Example variables include calculating NOI using higher than market vacancy rates or by increasing the estimated repairs and maintenance expense for future years - both of

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Corporate Finance Institute® Advance your career www.corporatefinanceinstitute.com which put downward pressure on the normalized NOI figure. Even keeping cap rates constant, this lower-than-market NOI figure would equate to a lower estimate of value, using the direct capitalization method. Many lenders also use a higher-than-market test cap rate though, which puts additional downward pressure on value estimates. It’s not uncommon, in a really hot market (where cap rates are compressed), to see a lender’s “value estimate” come in considerably lower than the appraiser’s estimate of “market” value. Neither is right or wrong, they’re just different approaches – the former being more dynamic, changing in real time with market forces, and the latter being more conservative, informed by historical norms rather than current conditions.