Overcoming Financing Obstacles

By Tony Petosa and Nick Bertino

Just as you prepare to take advantage of the low interest rate environment and decide to refinance your existing property or pursue an acquisition with debt, you find that obtaining the level of financing necessary isn't as neat and simple as initially imagined.  As you start to dig deeper into the transaction, you find that there are potential obstacles to your financing objectives.  You may find that there is a lack of cash flow sufficient to support the necessary debt, that the existing loan has a prepayment penalty attached to it, or that the property you wish to purchase sits on leased land. 

Though each of these obstacles can be daunting, options are available to a borrower that may help you reach your financing objective.  The best way to address these obstacles is to understand what they are, how they affect the financing process and then explore the various ways to deal with them.

Insufficient Cash Flow

During a financing transaction, you discover that the net operating income of the property is not sufficient to service the desired debt.  You wish to proceed with the financing, however, and do not want to (or may not be able to) wait until the property reaches a stabilized or optimum income level before financing.  The reasons for this may vary:  maturation of an existing loan; locking in an attractive interest rate; expansion or renovation to compete with other properties; repositioning of the property for sale or increased lease rates/rent; or other capital requirements.

Knowing this, the capital markets have developed several bridge-financing programs for properties that have upside potential in the near future.  These are often referred to as structured loans and are usually loan amounts of $3 million and above.  The three structures discussed below are just some of the methods the capital markets are utilizing to help "bridge the gap" from current financing needs until the property reaches a stabilized level whereby permanent long-term financing can be placed on it.   

Interest-only Financing during the initial years of the term allows an owner to have a more reasonable monthly payment that can provide the property with a sufficient debt service coverage ratio while it re-stabilizes. 

A Debt Service Reserve is a fund in which moneys are set aside by a borrower to make entire or partial loan payments in the event that cash generated by operations is insufficient to satisfy the debt service payments.  The debt service reserve fund is usually funded at the close of the loan or it can be structured as an accrual that increases the loan balance.  Debt service reserves are common with construction loans but may also be used with renovation or expansion properties that have not stabilized.

A Holdback is an effective way to lock in an attractive interest rate and a full loan amount.  The lender commits to the full loan amount but only funds that portion of the loan that is supported by the current net operating income of the property.  As the performance of the property improves and begins to reach or surpass certain performance tests, such as debt service coverage ratios or loan-to-value thresholds, the lender begins to fund the remaining debt until the full loan amount has been issued.

With interest rates remaining relatively low and an abundance of available capital, you have many different options to pursue in order to secure an attractive loan.  However, in order to get the lender comfortable with doing the loan and finally securing it, the borrower must be able document and support the loan request with operating statements, projections, improvement plans, market and economy information, sponsorship information and a well-defined exit strategy. 

Prepayment Premiums

In this low interest rate environment, you are faced with a dilemma:  should you refinance now and pay the prepayment penalty on an existing loan, or should you wait until the end of the prepayment penalty period and hope that interest rates are still attractive when you refinance at that point in time?  To better answer this question, you need to understand a common prepayment penalty: yield maintenance as well as what type of loan normally has yield maintenance, how to overcome it, and how it can benefit a borrower to pay the prepayment premium.       

What is Yield Maintenance?  Yield Maintenance is a prepayment penalty that allows a lender to attain the same yield on a loan as if the borrower had made all scheduled mortgage payments until maturity in the event the borrower pays off the loan before maturity.  Yield maintenance premiums are designed to make lenders whole in the event of an early prepayment by a borrower. 

What type of loan requires Yield Maintenance?  Generally speaking, fixed rate loans are the loans that require yield maintenance or its proxy, defeasance.  These types of loans are often pooled with other loans and then "securitized", meaning that there has been an issuance of a new publicly traded financial instrument, such as bonds, which are secured by the pooled assets.  This process allows these loans to often provide more aggressive terms than traditional portfolio loans.  These loans are popular due to favorable fixed interest rates, longer amortization, higher leverage/less required equity, and limited personal liability.  In exchange for these favorable traits, these loans require that they attain the yield that was originally agreed upon at the inception of the loan. 

How to overcome yield maintenance?  There are a couple of methods that can help you overcome the prepayment penalty.  The penalty could be added to a new loan and spread out over the term of the new loan, or a new loan could be structured where the interest rate is locked in advance to match the maturity of the prepayment period.

What are the benefits of financing before the Yield Maintenance period expires?  Not every financing transaction that has a prepayment penalty should be automatically viewed as a non-starter.  It generally makes sense to prepay a loan if the borrower is extending the loan term and/or refinancing at higher loan proceeds.  You may find it to be in your best interest, literally, to refinance in the current low interest rate environment and pay the prepayment penalty.  Refinancing while interest rates are low may result in a short recapture period of the prepayment penalty.  You may be able to generate equity retrieval, while reducing annual debt service, thereby providing cash out and additional cash flow.  With some analysis and a little due diligence, you may find that it is worthwhile to go forward with the financing process and secure a new, long-term, low interest rate loan.

Ground Leases

Once you have identified a property and decide to purchase it, you may find that the property sits on a ground lease.  In a conventional commercial real estate loan transaction, a borrower is the fee simple owner of a piece of property and a lender agrees to lend money to the borrower.  A ground lease, in addition to the various obstacles previously mentioned, can complicate a mortgage loan.       

What is a Ground Lease?  Typically, a ground lease is a lease whereby the owner of the land (ground lessor) leases or gives the right of use of land to a tenant (ground lessee) for a long period of time (usually more than 30 years) to develop the land in an agreed upon fashion so that both the ground lessor and ground lessee share in the resulting cash flows.      

Why is it so important to understand leasehold issues?  To begin with, it may affect your decision to buy.  For example, you should know the length of the remaining lease term, what happens to the improvements at the end of the lease term, and how increases in the ground lease payments are determined.  These are the main issues an investor should understand before deciding to buy.

A leasehold may also affect your ability to obtain financing on the property.  Lease provisions regarding such matters as future rent increases and the expiration date of the lease may impact the willingness of a lender to finance the proposed acquisition, or, at the very least, affect the loan terms.  Generally, lenders prefer leases that provide certainty as to what the future lease payments will be.  For example, a stated percentage increase is preferred to an increase based on future reappraisal. 

Loan terms such as the amortization period are also a function of the length of the ground lease, as the loan needs to fully amortize prior to lease termination.  Lease provisions such as lender notification on default are also important to loan underwriters. Lease terms may also affect the investor's ability to resell the property in the future as sale capitalization rates can rise substantially as leasehold properties near lease termination.

How to overcome leasehold issues?  There are a few methods to address leasehold issues.  You could investigate the option of obtaining a shorter-term, fully amortizing loan to pay the loan off prior to the lease expiration date.  Or, the investor may approach the ground lessee/seller about financing the purchase with a seller carryback in which the seller, in essence, acts as the lender.  The investor can also inquire whether the ground lessor is willing to extend the lease term.  Finally, the investor can inquire whether it is possible to purchase the fee interest and "merge" the leasehold interest in a single transaction.

The situations described previously are just a few of a myriad of potential obstacles that may hinder your financing objectives.  Before deciding not to pursue the process, we recommend that you consult with a mortgage professional to see what options are available to you.  With some analysis, you may find financing alternatives that, though they may be different from your initial goal, may end up fulfilling your ultimate financing objective.

Tony Petosa is Regional Director and Nick Bertino is Associate Director for Wells Fargo Commercial Mortgage.  They specialize in arranging financing on manufactured home communities and RV resorts, offering both direct and correspondent lending programs.  Petosa and Bertino can be reached at 760/438-2153; 760/438-8710 fax; and via email:  anthony.j.petosa@wellsfargo.com, bertinn@wellsfargo.com.