Institutional Lenders Offer Viable Financing Alternatives
Institutional lenders such as life insurance companies and Wall Street conduit lenders offer various financing options for commercial real estate ventures. In tight economic circumstances, commercial real estate professionals carefully should study the available options to make wise decisions for themselves and their clients.
Life Insurance Company Lenders
Life insurance companies traditionally provide long-term, fixed-rate mortgages on commercial income property as part of their investment strategy.
The benefits of life insurance company financing include the ability to lock in a long-term fixed-rate mortgage, and the opportunity to develop a relationship with an institutional lender that has the flexibility to modify or amend notes of credit if future circumstances deem it necessary. For example, when a life insurance company borrower has demonstrated a solid payment record, it may be feasible to obtain additional funds to improve the property, thereby attracting new tenants and higher rents. Life insurance companies also have the flexibility to modify existing loans with an additional advance, or possibly release an out parcel from the lien's security. Drawbacks of life insurance company loans include upfront expenses and the yield maintenance feature.
Life insurance companies have an appetite for all types of commercial properties. Credit tenant lease deals also are desirable properties to finance. Currently lenders favor income-oriented investments, such as apartments, community shopping centers, and industrial properties. Hospitality properties are the most difficult property type to finance in the current economic environment.
Most life insurance companies use commercial mortgage bankers to originate and service loans. In addition, mortgage bankers generally assist in closing loans, servicing payment collections, and troubleshooting other borrower needs.
Wall Street conduit lenders create commercial mortgage pools with funds from commercial mortgage-backed securities. These pools are divided into traunches, in which the least-riskiest portion of the cash flows produced by the loans' repayment are rated. The funds in this portion are referred to as A pieces, and the balance of the funds is referred to as the subordinate levels, or B pieces. B pieces generally carry more risk and exposure until amortization of the pool elevates them into rated positions. These funds then are securitized and resold as CMBS.
An advantage of conduit financing is that it can generate longer amortizations; however, this type of financing offers very little post-closing flexibility. Since the ownership of the mortgage is no longer intact — it is split into traunches — there is no possibility of amending or modifying the note.
A CMBS loan application typically specifies a floor interest rate, and a set spread above the Treasury yield is used as the benchmark for the loan. The requested financing amount is stated in the application, but usually it is conditioned upon the underwriteable cash flow as determined by the lender in its due diligence process. The debt coverage ratio drives the loan amount with net operating income typically based on the last 12 months' operating history. Advanced funds for third-party reports and fees are required.
Comparison of Terms
Although institutional lenders and Wall Street conduits both offer commercial loans, the way in which each entity handles them and the terms they offer may differ.
Loan amounts are calculated or sized based upon the borrower's ability to repay the debt. Deriving a supportable NOI based upon market rents and expenses provides the basis for calculation of value via capitalization. Lenders use thresholds such as loan to value and DCR to calculate a loan.
Typically institutional lenders and Wall Street conduits will finance a maximum of 75 percent LTV if the debt coverage provides a sufficient cushion, for example, 1.20:1 to 1.25:1. The DCR is calculated as NOI less tenant improvements and leasing commissions, where appropriate, divided by annual debt service. Amortization periods from 15 years to 20 years are typical with newer properties qualifying for 25-year amortization. Loan terms of 10 years to 20 years also are typical.
Recourse vs. Non-Recourse.
Sometimes institutional lenders provide non-recourse financing on qualified commercial real estate for stabilized properties with responsible ownership and management and typically lower LTV (65 percent or less). Depending on LTV and property type, as well as terms and amortization, the lender may require some recourse. In cases where a lender needs a certain property type to balance its portfolio, it may be less restrictive. Recourse may vary from 25 percent to 100 percent of the outstanding balance. This is sometimes structured to “burn off” as the loan amortizes or the property meets stabilized occupancy.
In all cases, the loan will have to be personally guaranteed for carve outs, which may include fraud, misuse of insurance or condemnation proceeds, failure to apply rents to the loan balance or operating expenses after a default, unpaid liens or public assessments, or any transfer of the property interest without the lender's consent.
Institutional lenders commit to funding long-term commercial mortgages at fixed interest rates and rely on the yield to make a profit. As a result, it is widely accepted that a borrower should guarantee the interest rate for the agreed-upon loan term. To ensure this, a yield maintenance formula is included in the loan documents for typical institutional lenders. Yield maintenance provides that the lender receives an amount sufficient to net the full interest amount in the event of early prepayment.
Wall Street conduit loan documents include a defeasance provision, which stipulates that if the borrower chooses to prepay a loan prior to maturity, it must replace the investment by purchasing a bond in favor of the lender that will make the lender whole with regard to yield. Typically, borrowers purchase U.S. Treasury bonds.
Both institutional and conduit lenders typically price long-term fixed-rate mortgage loans based upon yields available on comparable term U.S. Treasuries plus a spread to compensate for the additional risk associated with making a mortgage, as compared to buying a Treasury note. Currently, spreads of 250 basis points to 270 basis points (2.5 percent to 2.7 percent), depending on property type, are the norm, which result in an interest rate of 7.15 percent to 7.35 percent.
Institutional lenders establish a floor rate that they will not go below, regardless of the Treasury yield. This can be confusing for borrowers who typically think that interest rates will continue to decline as the Federal Reserve Board lowers the discount rate. These institutional investors have alternative investment vehicles, such as bonds, that they can use to achieve their desired yield.
Costs of Financing.
The cost of obtaining a fixed-rate long-term mortgage for a commercial property includes third-party reports by independent professionals such as an appraisal, property condition report, environmental report, and an “as-built” survey. Other costs include a fee to the mortgage banker, inspection fee to the lender, legal fees, state documentary stamp tax, and intangible taxes where applicable. As a rule of thumb, 2.5 percent to 3 percent of the total loan amount is a fair estimate of processing costs to obtain a commercial mortgage loan.