A pay and accrual split restores cash coverage without conceding the contract rate; whether the lender has given anything away depends on the exit value.
The borrower pays cash interest at a lower pay rate and the gap to the contract rate accrues, compounding, until maturity. On an illustrative 30,000,000 loan at 6.5 per cent with a 4.5 per cent pay rate for three years, cash DSCR rises from 0.85x to 1.22x, but the balance due at maturity grows to 31,919,535. To repay it the building's NOI must grow 9.3 per cent a year, or the exit cap rate fall to 5.65 per cent; on the base case none of the 1,919,535 accrued is collected.
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 pay rate and accrual rate split, sometimes called a pay and accrue structure or a deferred interest modification, is one of the most common workout tools for a loan whose income no longer covers its interest. It keeps the contract rate intact on paper, which matters to lenders who do not want to concede margin, while relieving the borrower's cash flow. Whether the lender has given anything away depends entirely on what the building will be worth when the accrual falls due.
| Input | Value |
|---|---|
| Loan balance | 30,000,000 |
| Contract rate | 6.5% |
| Pay rate (cash) | 4.5% |
| Accrual rate (deferred) | 2.0% |
| Modification term | 3 years |
| NOI today | 1,650,000 |
| Value today | 25,000,000 |
| NOI growth, exit cap rate (base case) | 3.0%, 6.75% |
At 6.5 per cent the loan costs 1,950,000 a year against 1,650,000 of NOI: a DSCR of 0.85x, and a borrower that has to inject cash every year or default. At a 4.5 per cent pay rate the cash interest is 1,350,000 and DSCR is 1.22x. The building can carry the loan again, as long as nobody asks for the other 2.0 per cent until maturity.
Agreements usually make the deferred interest itself bear interest at the contract rate, so the accrual compounds. Interest due each year is 6.5 per cent of principal plus accrued interest; the cash paid is 4.5 per cent of principal; the rest is added.
| Year | Interest due | Cash paid | Accrued in year | Balance due |
|---|---|---|---|---|
| 1 | 1,950,000 | 1,350,000 | 600,000 | 30,600,000 |
| 2 | 1,989,000 | 1,350,000 | 639,000 | 31,239,000 |
| 3 | 2,030,535 | 1,350,000 | 680,535 | 31,919,535 |
Accruedt = Accruedt−1 + contract rate × (principal + Accruedt−1) − pay rate × principal
In Excel, with principal in B1, contract rate in B2, pay rate in B3 and last year's accrued in C5: =C5+$B$2*($B$1+C5)-$B$3*$B$1. Simple, non-compounding accrual would give 1,800,000; compounding adds 119,535.
On the base case NOI grows 3.0 per cent a year to 1,803,000, and at a 6.75 per cent cap rate the building is worth 26,711,104 at maturity. That is less than the 30,000,000 of principal, let alone the 31,919,535 balance: LTV at maturity is 119.5 per cent, almost exactly where it is today at 120 per cent. A sale at that value leaves a principal shortfall of 3,288,896 and recovers nothing of the accrual. A refinancing at 65 per cent LTV would raise only 17,362,218.
To repay the full balance from a sale, NOI must reach 2,154,569 at the same cap rate, growth of 9.3 per cent a year, or the cap rate must compress to 5.65 per cent on base-case NOI. To refinance the full balance at 65 per cent LTV, NOI must reach 3,314,721, 26.2 per cent a year. The accrual is therefore not deferred income. It is an option on a recovery, and it should be valued as one, as in the scenario approach of extend or enforce a defaulted commercial loan.
| Pay rate | Cash interest | Cash DSCR | Accrued at maturity | Balance due |
|---|---|---|---|---|
| 3.5% | 1,050,000 | 1.57x | 2,879,302 | 32,879,302 |
| 4.0% | 1,200,000 | 1.38x | 2,399,419 | 32,399,419 |
| 4.5% | 1,350,000 | 1.22x | 1,919,535 | 31,919,535 |
| 5.0% | 1,500,000 | 1.10x | 1,439,651 | 31,439,651 |
| 5.5% | 1,650,000 | 1.00x | 959,768 | 30,959,768 |
| 6.5% | 1,950,000 | 0.85x | 0 | 30,000,000 |
The pay rate is the real negotiation. Set it at 4.58 per cent and cash DSCR is 1.20x, leaving a margin for leasing costs; set it at 5.5 per cent and the borrower pays out all of its NOI, with nothing for capex, which usually means the building deteriorates and the exit value with it. A lender that takes more cash today is often protecting its principal better than one that holds out for a larger accrual it will not collect.
All figures are illustrative. Real modifications often add a cash sweep, a paydown, an exit fee or a sharing of upside above a threshold, each of which changes who bears the shortfall.
The extension, with its cash flows and the recovery it buys, is modelled in the free workbook for this case.
The part of the contract interest that is not paid in cash but added to the balance and due at maturity. With a 6.5 per cent contract rate and a 4.5 per cent pay rate, the accrual rate is 2.0 per cent. On a 30,000,000 loan it adds 600,000 in year 1 and, compounding, 1,919,535 over three years.
From the cash coverage the building can sustain with its capital spending funded, not from the contract rate. On 1,650,000 of NOI and a 30,000,000 loan, a 1.20x cash DSCR implies a pay rate of 4.58 per cent. A 5.5 per cent pay rate takes coverage to 1.00x and leaves nothing for capex.
Only if the exit value exceeds principal plus the accrual. In the illustrative case the building is worth 26,711,104 at maturity on base-case assumptions, below the 30,000,000 of principal, so none of the 1,919,535 accrued is recovered. Full repayment needs NOI growth of 9.3 per cent a year or a 5.65 per cent exit cap rate.
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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