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Land-lease Community
Financing: Challenges and Solutions
By Tony Petosa and Nick Bertino
In recent months, land-lease
community lenders and owners faced financing challenges
in a rising interest rate environment. The following
paragraphs identify the challenges encountered and
outline solutions that asset class savvy lenders have
developed to address these issues.
Challenge:
Rising interest rates, combined with the lender’s
minimum debt service coverage ratio (“DSCR”)
requirements, restrict the maximum available loan
proceeds an investor can achieve.
Solution:
Lower minimum DSCR requirements.
For several
years, lenders have sized maximum loan amounts on most
land-lease communities using a minimum DSCR requirement
of 1.20:1.00. For example, assume a land-lease
community has an underwritten annual net operating
income (“NOI”) of $500,000. The lender would require
that the NOI divided by the annual loan payment be no
less than 1.20. Now, let us assume that the property
qualifies for a loan that is priced at an interest rate
of 6.00% on a 30-year amortization schedule. The loan
constant (the rate at which both principal and interest
are paid) would then be approximately 7.19%. When the
lender applies the minimum DSCR requirement of 1.20, the
resulting maximum loan amount would be approximately
$5,795,000 (e.g. $500,000/1.20/.0719=$5,795,000). Now
assume interest rates have increased 50 basis points
since the loan amount was originally sized, resulting in
an interest rate of 6.50% and a loan constant of
approximately 7.58%. The original loan amount of
$5,795,000 would then not meet the 1.20 minimum DSCR
requirement (the DSCR would only be 1.14) and the loan
amount would need to be reduced. The simple solution,
then, would be for the lender to reduce its minimum DSCR
requirement, which many lenders are now showing a
willingness to do on a case-by-case basis. On
well-located, high quality properties, we have been
successful in getting lenders to reduce their minimum
DSCR requirement from 1.20:1.00 to 1.15:1:00. In the
example above, this lower DSCR requirement would enable
the borrower to achieve nearly the same level of loan
proceeds at a 6.50% interest rate that he or she would
have originally received at a 6.00% interest rate.
Challenge:
Purchasing a land-lease home community at an aggressive
cap rate, resulting in low cash flow after debt service
payment.
Solution:
Interest only payments.
In the fixed
rate markets, maximum amortization schedules on
land-lease communities typically have been 30 years.
Assume, for example, the acquisition of a land-lease
community producing an annual NOI of $375,000. Assume
the cap rate is 6.25%, which would result in a purchase
price of $6,000,000 ($375,000 / 0.0625 = $6,000,000).
If the buyer were to borrower 75% of the purchase price
($4,500,000), at an interest rate of 6.00%, for a
10-year loan with a 30-year amortization schedule, the
annual debt service would be approximately $324,000.
The resulting cash flow, after debt service, would be
approximately $51,000. Perhaps the buyer’s business
plan is to accept a low cash flow number during the
first two years of ownership and then implement a rent
increase after year two. In order to improve the
property’s cash flow in the early years of ownership, it
may make sense to ask if the lender would be willing to
provide interest only payments for the first two years
of the loan term with the 30-year amortization schedule
to kick in thereafter. This would provide the buyer
with a healthier cash flow because the debt service
during the first two years of the loan term would now be
$270,000 ($4,500,000 X 6.00% = $270,000). During the
first year of ownership, the expected cash flow would
more than double, increasing from $51,000 (based on a
30-year amortization schedule) to $105,000 (based on
interest only payments). The buyer can then implement
the rent increase after year 2 (as well as continue to
lease spaces if the community is not 100% occupied) to
help offset, and perhaps even overcome, any decrease in
cash flow that results when the 30-year amortization
schedule goes into effect. It is actually becoming
customary on higher leveraged transactions for fixed
rate lenders to offer interest only payments for up to
the first 2 to 3 years of the loan term. As a general
rule, longer periods of interest only (up to 5 years)
are more easily obtained on lower leveraged
transactions. In fact, we have successfully negotiated
interest only terms for the entire 10-year loan period
on some very low leverage transactions.
Challenge:
A property owner wants to refinance now in order to take
advantage of low interest rates, but the current
mortgage is subject to a defeasance or yield maintenance
penalty for the next 12 months.
Solution:
Forward rate lock.
As many
borrowers are aware, long term fixed interest rates
typically come along with prepayment penalties that, in
a lower interest rate environment, can be very expensive
to pay off early. As such, many borrowers will wait
until very near the end of the loan term before they
even consider refinancing. We suggest considering a
forward rate lock. Despite the recent fluctuation in
U.S. Treasury rates, interest rates are still very low
by historical standards. Furthermore, the cost to do a
forward rate lock has declined so significantly that it
may make sense to think about refinancing a property as
early as 12 months prior to the loan maturing.
Typically, lenders will charge for a forward rate lock
by simply adding basis points to the interest rate.
There was a time when doing a forward rate lock was
quite expensive. In fact, the longer out that a
borrower wished to lock an interest rate, the more
expensive the cost per month became. For example, if
the cost to lock an interest rate for 2 months was
0.04%, then the cost to lock for 3 months was 0.09%, the
cost to lock for 4 months was 0.16%, and so on. Today,
some lenders have demonstrated the ability to lock rate
for as long as 12 months at a cost of as little as 0.01%
per month. So, exploring the refinance of one’s
property well in advance may be well worth the time
spent. For example, if a property currently qualifies
for an interest rate of 6.00%, but is subject to a
prepayment penalty for 12 more months, the property
owner can eliminate any upward interest rate movement by
locking the interest rate 12 months advance, which would
only increase the interest rate to 6.12%. If that
property owner were to wait 12 months before locking
rate, the actual increase in Treasury rates could be
much higher.
Summary
As the capital
markets are constantly evolving, especially as it
relates to land-lease community financing, it is always
a good idea to be working with an experienced mortgage
banker who is up to speed on the latest strategies that
lenders and property owners employ to achieve more
favorable financing alternatives.
Tony Petosa
is Regional Director and Nick Bertino is Associate
Director for Wells Fargo Commercial Mortgage. They
specialize in arranging financing on land-lease
communities and RV resorts nationwide, offering
securitized and on-book loan products through both
direct and correspondent lending programs. Petosa and
Bertino can be reached at (760) 438-2153; (760) 438-8710
fax; and via email:
tpetosa@wellsfargo.com,
bertinn@wellsfargo.com.
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