An extension option is only as good as its conditions, and the cheque that satisfies them can be computed months before the test date.
The paydown an extension test needs is the loan less the smallest maximum loan the extension conditions allow: solve each test (debt yield, loan-to-value, DSCR) for the loan that just passes it, take the lowest, and pay down to it. On an illustrative 40,000,000 loan with 3,200,000 of NOI and a 52,000,000 appraisal, the three tests allow 37,647,059, 36,400,000 and 39,384,615, so loan-to-value binds and the paydown is 3,600,000, 9.00 per cent of the loan. Refinancing instead would cost an 8,800,000 equity cheque.
Worked in full in How to Read a Real Estate Loan Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most floating-rate bridge and transitional loans carry one or more extension options, and almost all of them are conditional. The conditions are usually written as minimum ratios on the extension date, and a borrower who fails one can typically buy compliance by prepaying principal. Knowing that number months ahead is the difference between an extension and a forced refinancing.
| Input | Value |
|---|---|
| Loan outstanding, interest-only | 40,000,000 |
| Interest rate | 6.25% |
| Net operating income at the test date | 3,200,000 |
| Appraised value at the test date | 52,000,000 |
| Extension condition: minimum debt yield | 8.50% |
| Extension condition: maximum loan-to-value | 70.00% |
| Extension condition: minimum DSCR | 1.30x |
On these numbers the loan fails all three tests: the debt yield is 8.00 per cent, the loan-to-value 76.92 per cent and the DSCR 1.28x on interest of 2,500,000.
Maximum loan = MIN(NOI ÷ minimum debt yield, value × maximum LTV, NOI ÷ (minimum DSCR × rate))
Paydown = MAX(loan − maximum loan, 0)
In Excel: =MAX(Loan-MIN(NOI/DY,Value*LTV,NOI/(DSCR*Rate)),0). The DSCR term assumes interest-only debt service on the reduced balance; if the agreement tests DSCR on a notional amortising constant, use that constant instead of the rate.
| Test | Formula | Maximum loan | Paydown on its own |
|---|---|---|---|
| Debt yield 8.50% | 3,200,000 ÷ 8.50% | 37,647,059 | 2,352,941 |
| LTV 70.00% | 52,000,000 × 70.00% | 36,400,000 | 3,600,000 |
| DSCR 1.30x | 3,200,000 ÷ (1.30 × 6.25%) | 39,384,615 | 615,385 |
The binding test is loan-to-value. Paying down 3,600,000 leaves 36,400,000, and the loan then shows a debt yield of 8.79 per cent, a loan-to-value of exactly 70.00 per cent and a DSCR of 1.41x. All three pass. If the extension also carries a fee on the extended balance, say 0.25 per cent, that is a further 91,000.
The borrower needs 3,600,000. The alternative is to refinance: a new lender sizing at 60.00 per cent loan-to-value and a 10.00 per cent debt yield would lend at most 31,200,000, leaving a gap of 8,800,000. The extension paydown is the cheaper equity by a factor of 2.4, and it buys a year in which the business plan can still lift the income on which the next lender will size.
The test that binds depends on which number is weak. When income is low, debt yield binds and each 100,000 of extra NOI cuts the paydown by 1,176,471. When the appraisal is low, loan-to-value binds and income gains do nothing for the extension at all.
| NOI | Debt yield today | Binding test | Paydown |
|---|---|---|---|
| 2,800,000 | 7.00% | Debt yield | 7,058,824 |
| 3,000,000 | 7.50% | Debt yield | 4,705,882 |
| 3,200,000 | 8.00% | LTV | 3,600,000 |
| 3,400,000 | 8.50% | LTV | 3,600,000 |
| 3,600,000 | 9.00% | LTV | 3,600,000 |
| Appraised value | Maximum loan at 70% | Binding test | Paydown |
|---|---|---|---|
| 48,000,000 | 33,600,000 | LTV | 6,400,000 |
| 50,000,000 | 35,000,000 | LTV | 5,000,000 |
| 52,000,000 | 36,400,000 | LTV | 3,600,000 |
| 54,000,000 | 37,800,000 | Debt yield | 2,352,941 |
| 56,000,000 | 39,200,000 | Debt yield | 2,352,941 |
Below an NOI of 3,094,000 the debt yield test is the constraint; above it, the appraisal is. Leasing up to an NOI of 3,400,000 clears the debt yield test entirely and still leaves the same 3,600,000 to pay, because the appraisal has not moved. Conversely, 2,000,000 more on the appraisal saves 1,247,059, after which only income helps.
The common mistake is to size the paydown on the test the borrower is watching, usually debt yield, and turn up with 2,352,941 on a loan that also fails loan-to-value. The second is to treat the DSCR test as if a paydown could not cure it: on interest-only debt the interest falls with the loan, so the DSCR test is in effect a debt yield test at 1.30 × 6.25% = 8.125 per cent, and here it needs only 615,385. The third is to forget that the appraisal is usually the lender's, ordered for the extension, and can come in below the borrower's own view; the second table shows what each 2,000,000 of appraisal is worth.
The same three tests size a new loan in how to calculate the maximum loan, and the gap that a refinancing would leave is worked in paydown or preferred equity.
Solve every extension condition for its maximum loan, take the smallest and pay down to it. Here that is 3,600,000 against an 8,800,000 refinancing gap. Read the extension clause for which tests apply, on what income and which appraisal, and whether a paydown cure is allowed. The free workbook for this case prices the extension paydown alongside the cure, so the two can be compared on your own loan.
The one tied to the weakest number. With low income, debt yield binds; with a low appraisal, loan-to-value. In the illustrative case, below an NOI of 3,094,000 the 8.50 per cent debt yield test sets the paydown, and above it the 70.00 per cent LTV test does, at 3,600,000 on a 52,000,000 appraisal.
Usually to pay down, because extension conditions are set at origination and are looser than a new lender's sizing. In the example the extension needs 3,600,000 while a refinancing at 60.00 per cent LTV and a 10.00 per cent debt yield leaves a gap of 8,800,000, 2.4 times as much.
Because on interest-only debt a paydown cuts the loan and the interest together, so a DSCR test is really a debt yield test at the minimum DSCR times the rate. In the illustrative case 1.30x at 6.25 per cent equals an 8.125 per cent debt yield, below the 8.50 per cent test, so DSCR needs only 615,385 against 2,352,941 for debt yield and 3,600,000 for loan-to-value. Above a 6.54 per cent rate it would be the tighter of the two.
This article is one calculation from How to Read a Real Estate Loan Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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