2.4 Commercial Real Estate Debt — Mortgages, CMBS, and Mezzanine
Commercial property loans are limited by the smallest of three tests: loan-to-value, debt service coverage and debt yield. Many are pooled into CMBS, bonds backed by those loans, where losses run from the bottom layer, the B-piece, upward, and a special servicer takes over defaults. Mezzanine loans sit behind the main loan and are secured by the ownership interests, not the building.
Why it matters: The smallest test sets the loan, so one weak number can limit the whole deal.
Summary: Commercial mortgages are sized by the smallest of three tests: loan-to-value, debt service coverage and debt yield. Many are pooled into CMBS, where losses run from the B-piece up and a special servicer handles defaults; mezzanine loans sit behind them, secured by the ownership interests.
- At low rates value limits the loan; at high rates cash flow does ($80.0M vs $78.2M in the worked example).
- Debt yield (NOI ÷ loan) ignores interest rates and cap rates, so cheap money cannot inflate it.
- Refinancing at maturity is the main danger: a building with unchanged NOI can need $27.5M of new equity.
- CMBS loans usually require defeasance rather than prepayment, which can cost millions when rates have fallen.
Senior debt on a commercial property is typically originated as a commercial mortgage, secured directly against the building. Many such mortgages are subsequently pooled together and sold to investors as Commercial Mortgage-Backed Securities (CMBS) — the commercial real estate equivalent of the residential mortgage securitization covered in Volume I’s Part 11, tranched by seniority in the same waterfall structure. Mezzanine debt, sitting between senior debt and equity in the capital stack, is typically secured not against the property directly but against the equity ownership interests in the entity that owns the property — a legally distinct structure that allows it to be subordinated cleanly to the senior mortgage.
Lenders size a commercial mortgage with three tests and lend the smallest answer. The loan-to-value ratio (LTV) caps the loan as a share of appraised value. The debt service coverage ratio (DSCR), NOI ÷ annual debt service, caps the payment the property must carry. The debt yield, NOI ÷ loan, is the lender’s cash return if it took the building back on day one.
Use the Section 2.2: Cap Rates and Property Valuation building: NOI $8.00M, value $123.1M. Illustrative limits: LTV 65%, DSCR 1.25×, debt yield 9.0%, 30-year amortization. The loan constant, the annual payment per dollar borrowed (monthly payments), is 0.06813 at a 5.5% rate and 0.08186 at 7.25%.
| Test | Formula | At 5.5% | At 7.25% |
|---|---|---|---|
| LTV 65% | 0.65 × $123.1M | $80.0M | $80.0M |
| DSCR 1.25× | ($8.00M ÷ 1.25) ÷ loan constant | $93.9M | $78.2M |
| Debt yield 9% | $8.00M ÷ 0.09 | $88.9M | $88.9M |
| Loan offered | smallest of the three | $80.0M (LTV) | $78.2M (DSCR) |
At low rates value limits the loan; at high rates cash flow does. Debt yield ignores the rate, the amortization and the cap rate, so cheap money or interest-only terms cannot inflate it.
Regulation RR makes a securitization sponsor keep at least 5% of the credit risk. In CMBS, up to two B-piece buyers may hold the most junior slice instead, if they pay cash, review every loan, are independent of the sponsor and hold for at least five years. A defaulted loan moves to a special servicer, which decides whether to extend, modify or foreclose. Mezzanine lenders instead foreclose on the pledged ownership interests by a non-judicial UCC Article 9 sale, typically 45–60 days by practitioners’ account, far faster than a mortgage foreclosure; the intercreditor agreement usually lets them cure senior defaults or buy the senior loan.
Why CMBS loans are hard to repay early. CMBS bondholders were sold a fixed stream of payments, so conduit loans usually bar prepayment and offer defeasance instead: the borrower buys Treasury securities whose coupons and maturities replicate the remaining loan payments, and those securities replace the building as collateral. The cost depends on rates. Illustrative, with annual payments for simplicity: an $80.0M interest-only loan at 5.5% with five years left owes $4.40M a year plus $80.0M at maturity. If five-year Treasuries yield 4.0%, the replicating portfolio costs $4.40M × 4.452 + $80.0M × 0.822 = $85.3M, a $5.3M premium over the balance; at 6.0% it costs $4.40M × 4.212 + $80.0M × 0.747 = $78.3M. An owner who wants to sell or refinance after rates fall pays heavily to leave, so CMBS borrowers tend to refinance at maturity, which concentrates refinancing risk in the maturity year.
Size to the smallest of the LTV, DSCR and debt-yield answers, then stress the maturity: interest rate +2 points, cap rate +1 point. If the loan you could then refinance is smaller than the balance due, borrow less now or reserve the equity to fill the gap. A debt yield under about 8–9% at maturity signals dependence on cheap credit (a heuristic). For construction loans there is no NOI yet; use loan-to-cost and completion guarantees.
Assuming a maturing loan will refinance at its balance. A 2021 buyer pays $145.5M for the $8.00M-NOI building (5.5% cap rate) with a 70% interest-only loan of $101.8M at an illustrative 3.5% (DSCR 2.24×, debt yield 7.9%). At maturity, cap rate 7.0% and loan rate 7.25%: value $114.3M; new loan = smallest of 65% LTV ($74.3M), 1.25× DSCR ($78.2M) and 9% debt yield ($88.9M) = $74.3M. The owner needs $27.5M of new equity or loses the building, with NOI unchanged. The 7.9% debt yield was the warning.
What is a good DSCR for a commercial real estate loan?
Lenders commonly require about 1.20× to 1.35× for stabilized property, a market norm rather than a rule; an agency multifamily term sheet sets 1.25×. At 1.25×, NOI can fall 20% before the property stops covering its debt. Riskier property and floating-rate loans need more cushion.
What is debt yield and why do lenders use it?
Debt yield is NOI divided by the loan: the lender’s cash return if it owned the building outright. It depends on neither an appraiser’s cap rate nor the interest rate, so cheap money cannot inflate it. In the worked example a 9% minimum caps the loan at $88.9M whatever the rate.
What happens when a CMBS loan defaults?
The loan moves from the master servicer to a special servicer, which can extend it, modify it, sell the note or foreclose. Losses then run from the bottom of the structure up: B-piece holders first, AAA bonds last. Borrowers usually find a special servicer less flexible than a bank.
Lenders size a commercial mortgage by the smallest of the LTV, DSCR and debt-yield tests, so value limits the loan when rates are low and cash flow limits it when rates are high. CMBS pools such loans into tranches with losses running from the B-piece up, mezzanine lenders foreclose on ownership interests, and the largest danger is a maturity at which the building can no longer refinance its balance.
Four questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A building has $6.0M of NOI and a $100M appraisal. The lender requires 65% LTV, a 1.25× DSCR with a 0.08 loan constant, and a 9% debt yield. What loan is offered?
- $60.0M, set by the DSCR test
- $75.0M, set by the average of the tests
- $66.7M, set by the debt-yield test
- $65.0M, set by the LTV test
Reveal Answer
Answer: A. LTV gives $65.0M, DSCR gives $6.0M ÷ 1.25 ÷ 0.08 = $60.0M, debt yield gives $6.0M ÷ 0.09 = $66.7M; the smallest, $60.0M, is lent.
2. Why do lenders value the debt yield test?
- It rises automatically whenever market interest rates fall
- It ignores both the interest rate and the appraiser’s cap rate
- It measures the borrower’s personal net worth and liquidity
- It sets the loan from the property’s original purchase price
Reveal Answer
Answer: B. Debt yield = NOI ÷ loan, so cheap money or a low appraisal cap rate cannot inflate the loan it allows.
3. How is a mezzanine loan typically secured?
- By a guarantee issued by the senior mortgage lender
- By a second mortgage recorded against the building itself
- By a pledge of the equity in the entity that owns the property
- By the junior bonds issued by the CMBS trust
Reveal Answer
Answer: C. Securing it on the equity interests lets the mezzanine lender foreclose by a UCC Article 9 sale, much faster than a mortgage foreclosure.
4. A $50M loan matures. NOI is $4.0M, the market cap rate is 8.0%, and the new lender caps the loan at 65% LTV, its binding test. How much new equity is needed to repay the old loan?
- $15.0M
- $32.5M
- $0
- $17.5M
Reveal Answer
Answer: D. Value = $4.0M ÷ 0.08 = $50M; new loan = 65% × $50M = $32.5M; $50M − $32.5M = $17.5M must come from equity.
2.5 Project Finance — The Infrastructure Financing Model
Project finance funds a single asset, such as a power plant, through a special company whose debt is repaid only from the project’s own cash flow. Lenders work out how much to lend from the cash available to pay debt, using a minimum debt service coverage ratio, and check the whole life of the loan with the LLCR. They protect themselves with a cash waterfall, a debt service reserve and a web of contracts.
Why it matters: Lenders rely on the project, not the sponsor, so the contracts around it must be tight.
Summary: Project finance funds a single asset through a special purpose vehicle whose debt is repaid only from the project’s own cash flow. Lenders size debt from cash flow available for debt service using a minimum DSCR, check the whole life with the LLCR, and protect themselves with a cash waterfall, a debt service reserve and a web of contracts.
- $30M of CFADS for 15 years at 6% and 1.30× supports $224.1M of debt.
- When a P90 case at 1.20× binds, the same plant supports only $210.4M.
- In the worked example, a six-month DSRA covers two years of CFADS 13% below debt service without a payment default.
- Sizing on the base case can leave equity locked up for the whole loan life without any default.
Large infrastructure assets — toll roads, power plants, airports, pipelines — are typically financed through project finance: a dedicated, standalone legal entity called a Special Purpose Vehicle (SPV) is created specifically to build and operate the single asset, with debt raised against that SPV’s own projected cash flows rather than the sponsor company’s broader balance sheet. This structure is deliberately described as “non-recourse” or “limited recourse” financing — lenders can only claim against the SPV’s own assets and cash flows if the project fails, not against the sponsor’s other unrelated businesses.
Project debt is sized from cash flow available for debt service (CFADS): revenue minus operating costs, taxes and maintenance spending. Illustrative: CFADS of $30M a year for 15 years, a 6% loan, level debt service. Annuity factor = (1 − 1.06−15) ÷ 0.06 = 9.712. At a minimum DSCR of 1.30×, maximum debt service = $30M ÷ 1.30 = $23.08M, so debt = $23.08M × 9.712 = $224.1M.
The loan life coverage ratio (LLCR) is the present value of CFADS over the remaining loan life, at the debt rate, divided by debt outstanding (World Bank PPP Legal Resource Center): ($30M × 9.712) ÷ $224.1M = 1.30×, equal to the DSCR because CFADS is flat. When CFADS varies, lenders “sculpt” repayments so DSCR stays constant; DSCR tests each period, LLCR the whole life.
The contract web. Because lenders cannot reach the sponsor, they rely on contracts that push each risk onto a party able to bear it. A fixed-price, date-certain EPC contract (engineering, procurement and construction) moves cost and delay risk to the builder, backed by liquidated damages, pre-agreed payments for each day of delay, commonly sized to cover the debt service the delay puts at risk. An offtake agreement, such as a power purchase agreement, fixes the price or volume of what the project sells; an operations and maintenance contract fixes operating cost and performance; the concession or license grants the right to operate. Direct agreements give lenders step-in rights: if the SPV defaults, they can replace the operator before a counterparty terminates. Every gap in the chain, such as delay damages capped at a fraction of the cost of a two-year slip, is a risk that falls back on the debt.
Which case sets the debt. Lenders run more than one forecast. Illustrative: a solar plant with P50 CFADS (the median forecast) of $30M and P90 CFADS (exceeded in nine years out of ten) of $26M, tested at 1.30× on P50 and 1.20× on P90. Debt service allowed = the smaller of $30M ÷ 1.30 = $23.08M and $26M ÷ 1.20 = $21.67M, so P90 binds and debt = $21.67M × 9.712 = $210.4M instead of $224.1M. That $13.7M of extra equity is what keeps a poor resource year from hitting the lock-up.
Project cash is paid in a fixed order, the cash waterfall: operating costs and taxes; senior debt service; top-up of the debt service reserve account (DSRA), commonly six months of debt service (a convention, not a rule); maintenance reserve; a lock-up test (say, no dividends below 1.20× DSCR); then distributions.
A turbine fault cuts CFADS to $20M in years 3 and 4. DSCR = $20M ÷ $23.08M = 0.87×. The $3.08M yearly shortfall ($6.15M in total) is paid from a DSRA of $23.08M ÷ 2 = $11.54M, and lock-up blocks dividends. Measured at the start of year 3, with both bad years ahead, the LLCR is still 1.21× (present value of the remaining CFADS, $247.2M, ÷ debt outstanding, $204.3M), so the loan remains repayable over its life and lenders have reason to waive rather than accelerate. Without the reserve, year 3 is a payment default.
Project finance is like a parent setting up a separate, ring-fenced trust fund specifically for one child’s education, rather than simply promising to pay from their own general household budget — if that specific fund runs short, the child’s other siblings’ finances remain completely untouched. An infrastructure SPV ring-fences a single project’s risk in exactly the same way, protecting the sponsor’s other, unrelated business interests from that specific project’s failure.
Size project debt on a downside case, such as P90 output for a solar or wind plant (the level exceeded with 90% probability) or low-case traffic for a toll road. If the downside LLCR is below about 1.10×, add equity, lengthen the tenor or strengthen the contract. Illustrative minimum DSCRs rise with revenue risk: about 1.20–1.30× for availability payments from a creditworthy government, 1.40× or more for traffic or market-price revenue. These are heuristics; each lender sets its own.
Sizing on the base case and calling it safe because it is “non-recourse”. Size at 1.30× on $30M of expected CFADS, then let actual CFADS run 20% lower at $24M: DSCR = $24M ÷ $23.08M = 1.04×. The project never defaults, but it sits below a 1.20× lock-up every year, so equity receives nothing for 15 years. Size on the downside case and check the lock-up against it.
What is the difference between DSCR and LLCR?
DSCR compares one period’s cash flow with that period’s debt service, so it catches a bad year. LLCR compares the present value of all remaining cash flow with the debt outstanding, so it shows whether the loan can be repaid in total. A project can breach DSCR for a year with LLCR above 1.0×.
What is a debt service reserve account?
A DSRA is cash, usually about six months of debt service, set aside from project cash flow (or covered by a bank letter of credit) for lenders to draw when operating cash falls short. In the worked example an $11.54M DSRA covers a $6.15M two-year shortfall and prevents a payment default.
Is project finance really non-recourse?
Mostly. Once the project operates, lenders cannot claim against the sponsor’s other businesses, but sponsors usually give completion support during construction, such as cost-overrun funding or a guarantee until the plant passes its tests. That is why it is often called limited-recourse finance.
Project finance lends to a single-asset SPV against its own cash flow: debt is sized from CFADS at a minimum DSCR on a downside case, the LLCR checks repayment over the loan’s whole life, and a cash waterfall, a debt service reserve and lock-up tests protect lenders. Contracts such as EPC, offtake and direct agreements push each risk onto a party able to bear it, and sponsors usually support construction, so the finance is limited-recourse rather than fully non-recourse.
Four questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A project has $12M of CFADS a year for 10 years. The loan rate is 7% with level debt service and a 1.25× minimum DSCR. How much debt can it support?
- About $67.4M
- About $84.3M
- About $53.9M
- About $96.0M
Reveal Answer
Answer: A. Maximum debt service = $12M ÷ 1.25 = $9.6M; annuity factor (1 − 1.07⁻¹⁰) ÷ 0.07 = 7.024; debt = $9.6M × 7.024 ≈ $67.4M.
2. What does the loan life coverage ratio measure that the DSCR does not?
- The share of project revenue covered by the offtake contract
- The ratio of the project’s total debt to its construction cost
- One period’s cash flow against that same period’s debt service
- Present value of all remaining CFADS against the debt outstanding
Reveal Answer
Answer: D. DSCR tests a single period; LLCR tests whether cash flow over the whole remaining loan life can repay the debt.
3. Annual debt service is $20M and the debt service reserve holds six months’ worth. In a bad year CFADS falls to $16M. How much is left in the reserve after it covers the shortfall?
- $0
- $6M
- $10M
- $4M
Reveal Answer
Answer: B. The reserve starts at $20M ÷ 2 = $10M; the shortfall is $20M − $16M = $4M; $10M − $4M = $6M remains.
4. Why is project finance often called limited-recourse rather than non-recourse?
- Lenders can always claim the sponsor’s other businesses
- Equity investors are repaid before the senior lenders
- Sponsors usually back the project during construction
- Governments guarantee all project finance debt by law
Reveal Answer
Answer: C. Completion support such as cost-overrun funding or guarantees until the plant passes its tests gives lenders recourse to the sponsor before operations begin.
- Regulation RR, 12 CFR Part 244 — 5% risk retention and CMBS third-party (B-piece) purchaser conditions
- Federal Reserve, Financial Stability Report, May 2026: asset valuations — CRE price declines mid-2022 to early 2024, cap rates near historical average, maturing CRE debt
- World Bank PPP Legal Resource Center, issues in project-financed transactions — LLCR and DSCR definitions