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 • 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
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
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
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?
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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?
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
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
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
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
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!
“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
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
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)
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
“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
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!!!!!
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
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!
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
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