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Overcoming Financing Obstacles
By Tony Petosa and Nick Bertino
Just as you prepare to take advantage of the low
interest rate environment and decide to refinance your
existing property or pursue an acquisition with debt,
you find that obtaining the level of financing necessary
isn’t as neat and simple as initially imagined. As you
start to dig deeper into the transaction, you find that
there are potential obstacles to your financing
objectives. You may find that there is a lack of cash
flow sufficient to support the necessary debt, that the
existing loan has a prepayment penalty attached to it,
or that the property you wish to purchase sits on leased
land.
Though each of these obstacles can be
daunting, options are available to a borrower that may
help you reach your financing objective. The best way
to address these obstacles is to understand what they
are, how they affect the financing process and then
explore the various ways to deal with them.
Insufficient Cash Flow
During a financing transaction, you
discover that the net operating income of the property
is not sufficient to service the desired debt. You wish
to proceed with the financing, however, and do not want
to (or may not be able to) wait until the property
reaches a stabilized or optimum income level before
financing. The reasons for this may vary: maturation
of an existing loan; locking in an attractive interest
rate; expansion or renovation to compete with other
properties; repositioning of the property for sale or
increased lease rates/rent; or other capital
requirements.
Knowing this, the capital markets
have developed several bridge-financing programs for
properties that have upside potential in the near
future. These are often referred to as structured loans
and are usually loan amounts of $3 million and above.
The three structures discussed below are just some of
the methods the capital markets are utilizing to help
“bridge the gap” from current financing needs until the
property reaches a stabilized level whereby permanent
long-term financing can be placed on it.
Interest-only Financing
during the initial years of the term allows an owner
to have a more reasonable monthly payment that can
provide the property with a sufficient debt service
coverage ratio while it re-stabilizes.
A Debt Service Reserve is a
fund in which moneys are set aside by a borrower to make
entire or partial loan payments in the event that cash
generated by operations is insufficient to satisfy the
debt service payments. The debt service reserve fund is
usually funded at the close of the loan or it can be
structured as an accrual that increases the loan
balance. Debt service reserves are common with
construction loans but may also be used with renovation
or expansion properties that have not stabilized.
A Holdback
is an effective way to lock in an attractive
interest rate and a full loan amount. The lender
commits to the full loan amount but only funds that
portion of the loan that is supported by the current net
operating income of the property. As the performance of
the property improves and begins to reach or surpass
certain performance tests, such as debt service coverage
ratios or loan-to-value thresholds, the lender begins to
fund the remaining debt until the full loan amount has
been issued.
With interest rates remaining
relatively low and an abundance of available capital,
you have many different options to pursue in order to
secure an attractive loan. However, in order to get the
lender comfortable with doing the loan and finally
securing it, the borrower must be able document and
support the loan request with operating statements,
projections, improvement plans, market and economy
information, sponsorship information and a well-defined
exit strategy.
Prepayment Premiums
In this low interest rate
environment, you are faced with a dilemma: should you
refinance now and pay the prepayment penalty on an
existing loan, or should you wait until the end of the
prepayment penalty period and hope that interest rates
are still attractive when you refinance at that point in
time? To better answer this question, you need to
understand a common prepayment penalty: yield
maintenance as well as what type of loan normally has
yield maintenance, how to overcome it, and how it can
benefit a borrower to pay the prepayment premium.
What is Yield Maintenance? Yield
Maintenance is a prepayment penalty that allows a lender
to attain the same yield on a loan as if the borrower
had made all scheduled mortgage payments until maturity
in the event the borrower pays off the loan before
maturity. Yield maintenance premiums are designed to
make lenders whole in the event of an early prepayment
by a borrower.
What type of loan requires Yield
Maintenance? Generally speaking, fixed rate
loans are the loans that require yield maintenance or
its proxy, defeasance. These types of loans are often
pooled with other loans and then “securitized”, meaning
that there has been an issuance of a new publicly traded
financial instrument, such as bonds, which are secured
by the pooled assets. This process allows these loans
to often provide more aggressive terms than traditional
portfolio loans. These loans are popular due to
favorable fixed interest rates, longer amortization,
higher leverage/less required equity, and limited
personal liability. In exchange for these favorable
traits, these loans require that they attain the yield
that was originally agreed upon at the inception of the
loan.
How to overcome yield maintenance?
There are a couple of methods that can help you
overcome the prepayment penalty. The penalty could be
added to a new loan and spread out over the term of the
new loan, or a new loan could be structured where the
interest rate is locked in advance to match the maturity
of the prepayment period.
What are the benefits of financing
before the Yield Maintenance period expires? Not
every financing transaction that has a prepayment
penalty should be automatically viewed as a
non-starter. It generally makes sense to prepay a loan
if the borrower is extending the loan term and/or
refinancing at higher loan proceeds. You may find it to
be in your best interest, literally, to refinance in the
current low interest rate environment and pay the
prepayment penalty. Refinancing while interest rates
are low may result in a short recapture period of the
prepayment penalty. You may be able to generate equity
retrieval, while reducing annual debt service, thereby
providing cash out and additional cash flow. With some
analysis and a little due diligence, you may find that
it is worthwhile to go forward with the financing
process and secure a new, long-term, low interest rate
loan.
Ground Leases
Once you have identified a property
and decide to purchase it, you may find that the
property sits on a ground lease. In a conventional
commercial real estate loan transaction, a borrower is
the fee simple owner of a piece of property and a lender
agrees to lend money to the borrower. A ground lease,
in addition to the various obstacles previously
mentioned, can complicate a mortgage loan.
What is a Ground Lease?
Typically, a ground lease is a lease whereby the owner
of the land (ground lessor) leases or gives the right of
use of land to a tenant (ground lessee) for a long
period of time (usually more than 30 years) to develop
the land in an agreed upon fashion so that both the
ground lessor and ground lessee share in the resulting
cash flows.
Why is it so important to
understand leasehold issues? To begin with, it may
affect your decision to buy. For example, you should
know the length of the remaining lease term, what
happens to the improvements at the end of the lease
term, and how increases in the ground lease payments are
determined. These are the main issues an investor
should understand before deciding to buy.
A leasehold may also affect your
ability to obtain financing on the property. Lease
provisions regarding such matters as future rent
increases and the expiration date of the lease may
impact the willingness of a lender to finance the
proposed acquisition, or, at the very least, affect the
loan terms. Generally, lenders prefer leases that
provide certainty as to what the future lease payments
will be. For example, a stated percentage increase is
preferred to an increase based on future reappraisal.
Loan terms such as the amortization
period are also a function of the length of the ground
lease, as the loan needs to fully amortize prior to
lease termination. Lease provisions such as lender
notification on default are also important to loan
underwriters. Lease terms may also affect the investor’s
ability to resell the property in the future as sale
capitalization rates can rise substantially as leasehold
properties near lease termination.
How to overcome
leasehold issues?
There are a few
methods to address leasehold issues. You could
investigate the option of obtaining a shorter-term,
fully amortizing loan to pay the loan off prior to the
lease expiration date. Or, the investor may approach the
ground lessee/seller about financing the purchase with a
seller carryback in which the seller, in essence, acts
as the lender. The investor can also inquire whether
the ground lessor is willing to extend the lease term.
Finally, the investor can inquire whether it is possible
to purchase the fee interest and “merge” the leasehold
interest in a single transaction.
The situations described previously
are just a few of a myriad of potential obstacles that
may hinder your financing objectives. Before deciding
not to pursue the process, we recommend that you consult
with a mortgage professional to see what options are
available to you. With some analysis, you may find
financing alternatives that, though they may be
different from your initial goal, may end up fulfilling
your ultimate financing objective.
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Tony Petosa is Regional
Director and Nick Bertino is Associate Director for
Wells Fargo Commercial Mortgage. They specialize in
arranging financing on manufactured home communities and
RV resorts, offering both direct and correspondent
lending programs. Petosa and Bertino can be reached at
760/438-2153; 760/438-8710 fax; and via email:
anthony.j.petosa@wellsfargo.com,
bertinn@wellsfargo.com.
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