Land-lease Community Financing: Challenges and Solutions

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.