Debt financing for real estate
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Debt Financing for Real Estate. Discussion Outline Why Investors Use Leverage Behavioral Effects of Financing Underwriting Issues Types of Loans Legal Issues in Real Estate Finance. Why Borrow Against Real Estate?. Decrease Equity Exposure

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Debt Financing for Real Estate

  • Discussion Outline

    • Why Investors Use Leverage

    • Behavioral Effects of Financing

    • Underwriting Issues

    • Types of Loans

    • Legal Issues in Real Estate Finance


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Why Borrow Against Real Estate?

  • Decrease Equity Exposure

    • Extend limited resources in a capital intensive asset class

    • Limit risk exposure to any single asset

  • Tax Deductibility of Interest

    • Reduce taxable income

  • Positive Leverage

    • Before and after tax returns to equity are greater with than without debt

    • As long as debt costs less than equity, it takes less than it’s proportionate share of a property’s cash flow


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Positive Leverage

  • From an IRR perspective:

    • As long as the unlevered BTIRR > effective cost of debt, leverage is positive

      • i.e, as long as there is a positive spread between the cap rate (representing the WACC) and the interest rate on the loan, leverage is positive

    • Even if the unlevered ATIRR < effective cost of debt, leverage can still produce positive leverage because of the tax deductibility of interest


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How Debt Affects Real Estate Investment Behavior

  • Influences value at the margin

  • Increases focus on operational efficiency

  • Lengthens holding periods by reducing liquidity

  • Increases risk of loss of investment capital

  • Causes tax driven behaviors


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Debt and Value at the Margin

  • Adjusted Present Value = property’s market value PLUS the present value of a below market financing opportunity

    • Occurs typically with seller financing

      • Below market rate

      • Higher loan amount than commercially available

    • Occurred in early 1990’s with the RTC

      • Wholesale transfers of loans at significant discount to value

  • Current market debate – has access to such cheap capital inflated real estate prices today by pushing cap rates down relative to fundamentals?


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Focus on Operations

  • Small changes in NOI flow through 100% to equity returns

    • Changes can be in leasing or expense control

  • Points out the value of good management


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Debt and Market Liquidity

  • Structure and terms of most long term debt increases holding periods, illiquidity in the market

    • Loans are structured to lock in lender yields

      • Prepayment prohibitions, penaltes

    • Features compensate lenders for risks of extending credit

      • Default – loss of principal

      • Prepayment – potential opportunity cost of lost yield

      • Interest rate risk – loss of value due to changes in the yield curve


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Debt and Equity Principal Risk

  • Debt has legal priority over equity ownership

    • As well as financial payment priority

  • Equity owners must balance the benefits of positive leverage with the risk of foreclosure and loss of capital

    • Equity often accepts lower levered returns for reduced risk (ie, REITs, core investment funds)

  • Capital markets impose discipline on equity risks via underwriting criteria as well


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Debt and Taxes

  • Deductibility of interest expense enhances the “tax shield” already in place from depreciation

  • Tax impact is generally an individual issue

    • Private markets hold real estate primarily in “flow through” vehicles (partnerships, llc’s, etc.)

    • Tax motivated investors may structure deals for maximum tax benefit

      • Typically, does not effect pricing at the margin


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Is Inflation Good for Levered Real Estate?

  • In inflationary times, leverage benefits real estate equity returns

    • Debt principal is paid in the future with dollars that are worth less

  • Holds true only in hyper-inflationary periods

    • Loan pricing reflects the yield curve

      • Should have inflationary expectations built in


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The Underwriting Process

  • Steps in lender loan review: a mirror image of what the borrower is doing!

    • Market study

    • Appraisal

    • Analysis of borrower financial condition

    • Asset analysis

      • Physical condition

      • Financial history

      • Pro forma leasing and operating projections


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Residential vs. Commercial Lending

  • Residential lending:

    • Smaller in size

    • Non-recourse to the borrower

      • Totally dependent on market value of home for collateral

    • Fully pre-payable at any time

      • High percentage of prepayments at any given time

    • Federal government heavily involved in pricing and structuring through the RMBS market

    • Loan terms largely standardized, un-negotiable

      • Widely disseminated pricing information


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Residential vs. Commercial Lending (cont.)

  • Commercial Lending

    • Dominated by private sources of capital

      • A “relationship” business

      • Increasingly influenced by the public, CBMS markets

    • Highly dependent on local market information

    • Lender specialization by loan type

      • Source of funding, market knowledge

    • Terms and conditions highly negotiable


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Setting Loan Terms

  • Determining a loan amount

    • Based on ratio tests, collateral value

      • Debt coverage ratio

      • Loan to value ratio

  • Setting the terms and conditions

    • Pricing based on underlying cost of funds

      • plus premiums for default, inflation, and prepayment

    • Reps and warranties, performance covenants

    • Determination of sufficiency of collateral


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Alternative Loan Structures

  • Loan structures reflect a trade off of risk and return between lender and borrower

    • Lender evaluates looser underwriting conditions (ie., more risk) for greater return

    • Borrower evaluates more or less debt proceeds versus

      • Timing and security of cash flows

        • The “financial leverage” effect

      • Current return (less risk) vs. residual return (more risk)

      • Cost of incremental debt versus additional equity


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Fixed, Floating and Interest Only Loans

  • Fixed rate loans are the standard

  • Floating rate loans

    • Construction and mini-perms

    • Acquisition lines of credit

  • Interest only loans

    • “balloon” or “bullet” payment at maturity

    • Used for:

      • Construction

      • Acquisition lines of credit

      • Structured finance transactions


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Participating Loans

  • Lender trades risk for higher potential returns

    • Reduces LTV, DCR coverage

      → Increases loan amount

    • Takes a percentage of after debt service cash flows

      • Structured as “additional interest”

    • Total of fixed payment and percentage interest creates higher total yield on loan dollars invested


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More on Participating Loans

  • Borrower benefits:

    • Greater loan proceeds

      • Often cheaper than equity which might have to be raised from outside sources

    • Lower fixed debt payments

      • Less pressure on short term NOI

  • Borrower decision:

    • What is the incremental cost of borrowing the extra loan amount, vs. cost of equity?

    • If the deal IRR is weighted toward the residual, the lender’s participation in the residual is probably less than an equity investor’s would be


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More Alternatives

  • Land Sale Leaseback

    • Financing land separately from improvements

    • Higher total loan proceeds

      • Finances 100% of land value, vs. LTV if included in typical loan calculation

    • 100% of payments are tax deductible

      • Vs. only interest portion if financed by loan

  • Risk is in subordination provisions


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More Alternatives (cont.)

  • Accrual Loans

    • “Pay rate” < stated interest rate

    • Negative amortization situation

    • Tax benefits:

      • Creates greater tax shield → deductible interest is based on the accrued rate, not the pay rate

    • More risk to the lender → WHY?


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One More…….

  • Convertible Loans

    • Lender has an option to “convert” – ie, swap loan proceeds for partial equity ownership

      • Would convert if the equity value of the interest exceeds the mortgage balance at conversion date

    • Borrower benefits

      • Lower interest rate, greater current cash flow in exchange for potential loss of equity value in the future


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Legal Considerations In Real Estate Financing

  • Real estate cash flows can be legally allocated to different “interest” holders via the capital structure

  • The PV of each of these streams = value of the interests claimed by each layer of capital

  • The legal system also establishes control over other, non-monetary “interests”

    • Equity owners don’t necessarily get 100% of the “value” of real estate interests


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Possessory Interests

  • Possessory (current or potential) interest is a right to control some of the rights through some form of financial consideration

    • “Fee simple” ownership interest

    • Tenant’s leasehold interest


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Non- Possessory Interests

  • Non-possessory interest is a right to use real estate without ownership or financial consideration

  • Most pervasive form is the easement

    • Provides a right to use, but not legally own, an interest

      • Power lines, fire access

      • Some easements may be irrevocable

  • An easement can affect value

    + Right of way to reach the street

    -Power line running down the center of property


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Why Do Lenders Need Legal Consideration?

  • Mortgages are a passive investment in real estate

    • Mortgage gives them a claim to the stream of cash flows, but

    • Borrowers retain control over operations

  • Legal considerations impose discipline on borrowers, provide some framework for orderly conduct of the market

    Without ability to impose mortgage terms, debt would be prohibitively expensive!


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“Title”

  • Title is both a concept and a physical representation of ownership rights

    • The Title Policy presents you as the holder of the deed and the bundle of rights associated with ownership


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Title Assurance and Insurance

  • Title “Assurance”

    • Title provides a surety that you own and control the bundle of rights associated with a property

      • And that you have the right to seek financial redress if rights are misrepresented or not what you paid for

  • Title “Insurance”

    • An insurance policy that provide for monetary damages in the event of a failure of title assurance

      • Lenders and owners purchase these


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Loans and Title

  • Loans take a ‘first lien” on title

    • Are recognized in legal chain as having right to foreclose on equity ownership

    • Lenders are also issued a “lender’s title policy” securing their position in the “chain of title”

      (Property taxes actually have true priority at all times)


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Conveying Title

  • When you buy/sell real estate, you ‘convey” title to it

  • All restrictions/encumbrances are conveyed with it, unless otherwise removed

  • Some encumbrances are not removable

    • Easements, waterways

    • Considered to “run with the title”

  • Must have debt encumbrances either removed or assumed to convey title

    • Hence the effect on market liquidity if mortgage provisions prohibit repayment or transfer


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“Assuming” a Mortgage

  • The assumption shifts responsibility for the mortgage to a new owner

    • Purchase is “subject to” the mortgage lien on title

    • Approval of lender must be obtained

  • Assumption does not mean release of liability!

    • Payment and performance obligations are the buyer’s, but liability in event of default stays with the seller

    • Must have a “release” of mortgage


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Conveying Title - Deeds

  • The warranty deed is a legal document which evidences the conveyance/transfer of title

  • “Grantor” = seller

  • “Grantee” = buyer

  • Types of deeds

    • General→ covers all past ownership

    • Special → restricts assurance to just the holding period of the grantor

    • Quitclaim → no assurance of what the grantor or others in the “chain of title” might have controlled

      A General Warranty Deed is BEST!!!!!


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Other Conveyance Issues

  • Legal opinion

    • Need an qualified attorney’s opinion that title is clean and defensible

  • “Exceptions” to title

    • Items/conditions that create limits to title

    • Need to either accept or object to exceptions

      • Not all exceptions are bad things

  • Which of these exceptions are “acceptable” ?

    • Mortgages

    • Easements

    • Mechanics liens


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Recording Changes to Title

  • Public records exist for determining ownership of property

  • Should ALWAYS record title issues to avoid future conflicts over control of interests

    • Transfers

    • Easements

    • Mortgages

      • Lenders must have a recorded mortgage in order to “perfect” their mortgage rights

      • Think about how expensive debt would be if lenders could not protect their rights!


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The Loan Documents

  • The Mortgage

    • Secures the debt by establishing conditions for conveyance of collateral in event of default

    • Recorded on title

      • If a state is a “deed of trust” state – like Texas – then the “mortgage deed” actually conveys title to the lender in trust while the mortgage is outstanding

  • The Promissory Note

    • Establishes the debt obligation personally between lender and borrower

      • Provides right to pursue payment outside of the collateral


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Types of Defaults

  • Monetary

    • Failure to meet financial payment terms

    • Typically the more serious defaults, trigger foreclosure or workout

  • Non-monetary or “technical” defaults

    • Failure to meet “soft” terms and conditions

      • Ongoing ratio tests

      • Breach of covenant, rep or warranty

    • Recurring non-monetary defaults are red flags for potential future monetary defaults


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