Making Permanent Financing Work
Real estate financing used to be simple: if you needed capital, a local lender made the loan based on its evaluation of your creditworthiness and your property's value. However, the wizards of Wall Street have recently worked their financial structuring magic on the previously ignored area of real estate finance, making more capital available while increasing the complexity of available loans. Now, each capital source has its own objectives, and the loans they make include legal risks that vary considerably and may not be obvious. If a developer understands the structure of these loans, it can choose the mix of funding sources that best meets the capital needs of the project over its expected lifetime.
In underwriting a real estate loan, all lenders evaluate the developer's experience and the project's feasibility. Yet other variables influence which loan is best for a project. They include the product type (retail, multifamily, office, industrial, hospitality, etc.); the time in the project's life cycle; whether the lender looks primarily at the borrower or at the project as a source of repayment; the stability of, or likely increase in, the project's value; the developer's need for flexibility; and the exist strategy required by the lender for its loans. The first variable is simple: most lenders clearly state their preferences. The second variable is also readily ascertained since a limited number of lenders are willing to make and manage early stage loans for acquisition of unentitled land, construction loans and value-added loans for rehabilitation or repositioning of a project. The earlier in the project life cycle the loan is made, the greater the risk of nonpayment and the higher the costs. The other variables, particularly for permanent loans, are imposed by the source of the lender's funds.
Permanent financing for a project lasts about 10 to 20 years, usually providing for gradual amortization of the loan principal. Permanent loans require a project with a predictable cash flow and a stable tenant base. Traditional permanent real estate loans are low-rate, low-risk and based on a fairly low (40% to 80%) LTV ratio. Typically bank and insurance company originators hold and service these loans. Traditional permanent lenders heavily weigh the developer's track record, and often tailor deal-specific loan documents for their good customers.
Borrower net worth, financial covenants and debt service ratios over the loan term are emphasized, as well as property value. Personal guarantees of the borrower's principals are usually required. Rather than foreclosing, upon default, institutional lenders often modify traditional permanent real estate loans (imposing lock-boxes, extending maturity dates, lowering interest rates and making other concessions to borrowers) so that such loans are reinstated as performing loans. With the increase in securitized permanent loans (discussed later), many "traditional" lenders have now started underwriting and closing their loans to securitization standards so that if they need to adjust their balance sheets, these loans will be more easily marketable in the secondary market.
Through the past decade, permanent loans have increasingly been provided to developed projects with stable cash flow by nontraditional, securitized conduit lenders. LTV ratios and required project stability are similar to those in nonsecuritized permanent loans, but the loan terms are standardized to optimize predictable cash flow and resale into the secondary loan market and can't be as extensively negotiated as nonsecuritized loans. Because the conduit market won't tolerate erratic cash flow, these loans use impounds, tax services, prepayment penalties and other devices to regularize the payment stream.
Securitized loans structurally isolate the income from the property, which is treated as the sole source of repayment of the loan, requiring that the borrower be a special purpose entity that owns nothing other than the real property being developed. Many securitized loans also require additional structural protections (such as non-consolidation opinions). Such structural protections may increase the overall transaction costs to the borrower but these may be offset by the lower cost of capital provided by such programs. However, only limited personal guaranties are required.
Prepayment of securitized loans is particularly difficult and expensive as a borrower typically must "defease" the loan instead of paying it off, by providing governmental securities as substitute collateral if the borrower wishes to sell its real property. The income from such securities is used to make all the loan payments over time as originally scheduled. In return for this lack of flexibility, the securitized lending market often offers lower interest rates and simpler financial performance covenants, which may be attractive to a project that is sure to hit its projected numbers. Careful matching in advance of the type of permanent loan and its characteristics to the borrower's plans for its project can help borrowers avoid costly problems such as impediments to planned transfers of their project.