The A note is the loan a market lender would hold today; the B note is an option on the building's recovery and should be valued as one.
In an A/B note restructuring the A note is sized to what the property supports today on market terms, the lower of a coverage test and a loan-to-value test, and the rest of the claim becomes a B note paid only from future value. On an illustrative 60.0 million loan against a building worth 50.77, the A note is 38.08, set by a 75 per cent loan-to-value, and the B note 21.92. The B note is worth 10.21 today, 46.6 cents, and the split is worth 80.5 cents to the lender against 56.9 from enforcing.
Worked in full in The Real Estate Workout by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A loan of 60.0 sits on an office earning 3.30 of net operating income. At a 6.5 per cent valuation yield the building is worth 50.77, so loan-to-value is 118.2 per cent, and at a market rate of 6.25 per cent the whole loan would cover its interest only 0.88 times. The loan cannot be refinanced and the sponsor cannot repay it. The A/B split, sometimes called a hope note structure, is one of the standard ways out, and the arithmetic is mostly about where to draw the line between the two notes. The case is illustrative.
| Input | Value |
|---|---|
| Loan outstanding | 60.0 |
| Net operating income | 3.30 |
| Valuation yield | 6.5% |
| Market interest rate for a performing loan | 6.25% |
| Minimum interest cover on the A note | 1.30x |
| Maximum loan-to-value on the A note | 75% |
| B note: no coupon, repaid from sale proceeds in year 5 | |
| NOI growth a year; sale costs | 3% ; 2% |
| Discount rate for the B note | 12% |
Value = 3.30 / 6.5% = 50.77
A by coverage = NOI / (cover × rate) = 3.30 / (1.30 × 6.25%) = 40.62
A by loan-to-value = 75% × 50.77 = 38.08
A note = MIN(40.62, 38.08) = 38.08; B note = 60.0 − 38.08 = 21.92
In Excel: =MIN(B3/(B6*B5), B7*B3/B4) for the A note, with the loan in B2 and the inputs in table order below it, and =B2- the A note cell for the B note.
The A note is a performing loan on its own terms: interest of 2.38 a year, cover of 1.39 times and a debt yield of 8.67 per cent. Those are the terms on which a lender could hold it at par, or sell it, and that is the point of the test. An A note sized above what a new lender would lend at market terms is just the old loan with a new name. The 0.92 of income left after A note interest stays in the property to fund letting and capex, which is what makes the growth assumption credible.
The B note has no coupon and is repaid only from what a sale in year 5 produces above the A note. Forward NOI at exit is 3.83. Across four exit yields:
| Exit yield | Probability | Gross value | Net of costs | To the B note | Cents on B |
|---|---|---|---|---|---|
| 6.0% | 25% | 63.76 | 62.48 | 21.92 | 100.0 |
| 6.5% | 35% | 58.86 | 57.68 | 19.60 | 89.4 |
| 7.0% | 25% | 54.65 | 53.56 | 15.48 | 70.6 |
| 7.5% | 15% | 51.01 | 49.99 | 11.91 | 54.3 |
| Probability-weighted | 18.00 | 82.1 |
The probability-weighted recovery is 18.00 in year 5. Discounted at 12 per cent for five years it is worth 10.21 today, 46.6 cents on the B note's face. The B note carries most of the risk and none of the income, so the discount rate is closer to an equity return than to a loan rate, and the five years of waiting take about twice as much value as the exit uncertainty does: 7.79 against 3.92.
| Route | Present value | Cents on the 60.0 loan |
|---|---|---|
| A note, at par on market terms | 38.08 | |
| B note, probability-weighted at 12% | 10.21 | |
| A/B split, total | 48.29 | 80.5 |
| Enforce: 15% forced-sale discount, 6% costs, 2 years at 9%, rent in the interim ignored | 34.14 | 56.9 |
The split is worth 14.15 more than enforcing on these assumptions, because it avoids the forced-sale discount and keeps the building's recovery for the lender. The sponsor keeps an incentive only in the best case: at a 6.0 per cent exit it receives 2.48 after both notes; in the other three it receives nothing. A B note that the sponsor cannot see past is a B note the sponsor will stop working for, which is why many structures give the sponsor a share of proceeds above the A note.
| A note LTV | A note | B note | B note value | Cents on B | Lender total | Cents on loan |
|---|---|---|---|---|---|---|
| 65% | 33.00 | 27.00 | 13.09 | 48.5 | 46.09 | 76.8 |
| 70% | 35.54 | 24.46 | 11.65 | 47.6 | 47.19 | 78.7 |
| 75% | 38.08 | 21.92 | 10.21 | 46.6 | 48.29 | 80.5 |
| 80% | 40.62 | 19.38 | 8.77 | 45.3 | 49.39 | 82.3 |
A larger A note always looks better to the lender, because more of the claim is valued at par. But at 80 per cent the A note reaches the 1.30 times coverage limit as well, and it is at the edge of what a market lender would hold. The lender's real choice is between a smaller A note it can sell or hold as performing and a larger one that may default again.
Carrying the B note at face. The restructured position then shows 60.0 against a present value of 48.29, overstating the B note by 11.71, and the provision that should have been booked at the restructuring arrives later, usually at the moment of the sale. Value the B note as what it is, an option on the building's recovery, and provision against the gap on the day the split is signed.
Size the A note to the lower of coverage and loan-to-value on market terms, 38.08 here, and value the B note as a discounted, probability-weighted share of a future sale: 10.21, 46.6 cents. The book's Harbour Quay case prices four ways out of one broken loan, each discounted to today over its own timetable, in the free workbook for this case. For what time does to the alternative, see what a month of delay costs in an enforcement.
It is the B note of an A/B split: the part of the loan the property cannot support today, carried without a coupon and repaid only if a future sale or refinancing produces enough. In the illustrative case the 21.92 hope note recovers 18.00 on a probability-weighted basis in year 5, worth 10.21 today at 12 per cent.
Often, because it avoids the forced-sale discount and the cost of the process. On the illustrative loan the split is worth 48.29, 80.5 cents, against 34.14, 56.9 cents, from enforcing with a 15 per cent forced-sale discount, 6 per cent costs and two years of delay at 9 per cent.
At its expected recovery, not at face. Carrying the illustrative B note at 21.92 instead of its 10.21 present value overstates the position by 11.71 and defers the provision to the sale, which is the moment the lender can least afford it.
This article is one calculation from The Real Estate Workout. 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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