Name the test that created the gap, then price each dollar of it as fund cash against a coupon.
Work out which test created the gap, then price each dollar of it. A $60M bridge refinanced against an 11 per cent debt yield minimum raises only $48M, a $12M gap, even though NOI has risen 6.7 per cent. Filling it all with 13 per cent preferred equity costs $1.56M a year and leaves 1.05x coverage after the pref; a $6M paydown and $6M of pref cost $780k and leave 1.24x. The choice is fund liquidity against carry, and both sides have a number.
Worked in full in Real Estate Fund Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The case is the proceeds-gap example in the debt chapter of Real Estate Fund Management: an industrial portfolio bought with a $60M floating-rate bridge at 75 per cent LTV, refinanced three years later into a market with higher cap rates and higher debt yield minimums. The book gives the loan, the LTV, the $48M of proceeds and the $6M plus $6M solution. The NOI, the lender's cap rate, the credit box and the pref coupon below are the illustrative inputs the companion workbook adds to connect the two dates.
| Input | At origination | At refinancing |
|---|---|---|
| Loan / maximum LTV | $60M at 75% | 70% max |
| Net operating income | $4.95M | $5.28M |
| Cap rate used for value | 6.19% | 7.25% |
| Value | $80M | $72.83M |
| Debt yield | 8.25% achieved | 11% minimum |
| Minimum DSCR, rate (interest only) | n/a | 1.30x at 7.25% |
A lender lends the lowest of its tests, so compute all three before arguing about any of them.
LTV proceeds = NOI / cap rate × max LTV = $5.28M / 7.25% × 70% = $50.98M
Debt yield proceeds = NOI / minimum debt yield = $5.28M / 11% = $48.00M
DSCR proceeds = NOI / minimum DSCR / rate = $5.28M / 1.30 / 7.25% = $56.02M
Excel: =MIN(NOI/Cap*MaxLTV, NOI/MinDY, NOI/MinDSCR/Rate)
The debt yield binds at $48.0M. The gap is $60M less $48.0M, or $12.0M, 20 per cent of the original loan.
The asset performed: NOI rose from $4.95M to $5.28M, up 6.7 per cent. Value on the lender's cap rate fell 9.0 per cent, but the value test is not the one that binds. The loss of proceeds comes from the debt yield: the old loan ran at 8.25 per cent and the new minimum is 11 per cent, so the new lender demands 33.3 per cent more yield on every dollar than the old loan achieved. Proceeds under that test are NOI divided by the minimum, so a one-third rise in the minimum outweighs a 6.7 per cent rise in income.
The two tests swap over at a cap rate of max LTV times minimum debt yield: 70 per cent of 11 per cent, or 7.70 per cent. The lender's cap rate has 45bps to widen before LTV takes over. Until then, arguing about the valuation does not move the loan.
Waiting is not a route. Refinancing the full $60M at an 11 per cent debt yield needs $6.60M of NOI, 25 per cent above today. At 4 per cent growth that is 5.7 years away, on a loan that has already matured.
New senior debt of $48.0M at 7.25 per cent costs $3.48M a year, a senior DSCR of 1.52x. Whatever is not paid down from fund cash has to be filled by a junior tranche, here preferred equity at an illustrative 13 per cent.
| Paydown | Pref | Pref cost a year | DSCR after pref | Cash left a year | Effective LTV |
|---|---|---|---|---|---|
| $0M | $12M | $1.56M | 1.05x | $0.24M | 82.4% |
| $3M | $9M | $1.17M | 1.14x | $0.63M | 78.3% |
| $6M | $6M | $0.78M | 1.24x | $1.02M | 74.1% |
| $9M | $3M | $0.39M | 1.36x | $1.41M | 70.0% |
| $12M | $0M | $0.00M | 1.52x | $1.80M | 65.9% |
The book's solution is the highlighted row: $780k a year of pref coupon, 1.24x coverage once the pref is paid, and $1.02M a year left for the equity. Note the last column. Adding pref does not reduce leverage: senior plus pref is $54M on $72.83M of value, an effective 74.1 per cent, almost exactly where the bridge started. Only cash reduces it.
Every dollar of paydown saves 13 cents a year of pref coupon. So paying down beats pref whenever the fund's cash would earn less than 13 per cent elsewhere, after counting what that cash protects. That last clause is the real cost: reserves spent on this loan are not available for the next covenant test or capital call. A fund that pays the full $12M from liquidity gets the best coverage, 1.52x, and is the most exposed if a second asset needs support. The all-pref route keeps the cash but leaves coverage at 1.05x after the pref, so a small NOI miss sends the asset back to its investors for money.
The usual error is to blame valuation and negotiate the cap rate, when the test that binds does not use it. Here the lender's cap rate could fall 45bps or rise 45bps and proceeds would not change. The second error is to treat pref as equity because of its name. At 13 per cent it costs 5.75 points more than the senior loan, ranks ahead of the fund's own capital and leaves leverage where it was. It changes who is exposed and in what order, not how much is borrowed.
The proceeds-gap case, with the paydown and pref ladder live, is in the debt sizing workbook on the free workbook page for this book. For the same binding-test logic applied at the start of a project rather than at refinancing, read how much debt a loan-to-cost cap refuses.
Because proceeds follow the binding test, not income. Here NOI rose 6.7 per cent, but the old loan achieved a debt yield of only 8.25 per cent and the new lender requires a minimum of 11 per cent. Proceeds under that test are NOI divided by the minimum, so they fell from $60M to $48M.
Where the two tests give the same loan: cap rate equals maximum LTV times minimum debt yield. At 70 per cent and 11 per cent that is 7.70 per cent. Below it, debt yield binds and the valuation does not move proceeds; above it, every basis point of cap rate reduces the loan.
No. Senior debt plus pref ranks ahead of the common equity just as the old loan did. With $48M of senior and $6M of pref on $72.83M of value, the effective LTV is 74.1 per cent. Only a cash paydown reduces leverage; pref changes who bears the risk and in what order.
The proceeds-gap case is worked in the Chapter 10 debt workbook of Real Estate Fund Management. 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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