C
ommercial paper is one
of the primary capital sources in today's global financial markets.
Fortune 500 companies and other large corporations regularly sell
commercial paper to finance many types of expenditures. However,
security registration requirements, high transaction costs, public
disclosure of confidential information, and other significant barriers
have denied small borrowers access to the multibillion-dollar public
debt market.
Underwriters have
addressed these problems successfully and now offer small commercial
real estate borrowers below-prime-rate financing through variable rate
demand notes. VRDNs provide such borrowers with substantial debt
service savings over bank construction or mini-perm loans.
Uses and Benefits
Developers
and investors can use VRDNs to fund a multitude of commercial real
estate investment needs, including construction, acquisition financing,
permanent financing, and debt restructuring. Developers often use VRDNs
as mini-perm loans for multifamily projects because they have no
affordability restrictions such as those found in tax-exempt
multifamily development loans.
The VRDN program offers small commercial real estate borrowers the following benefits:
- amortization that small borrowers can customize to specific transactions;
- no requirement for public disclosure of sensitive or confidential information;
- optional principal prepayment without penalty;
- independent transactions that are not affected by other financings;
- small borrowers' ability to fund multi-project financings through a single transaction;
- no required Securities and Exchange Commission registration since the issues are secured with bank letters of credit; and
- the ability to convert to fixed-rate loans within the existing documentation with only nominal costs.
VRDNs
come with few restrictions. The trade-off for low rates is borrower
recourse. VRDNs have no capital transition expenditure limitations or
fund usage restrictions. A minimum $2 million dollar loan usually is
required.
VRDN Regulations
In
essence, VRDNs are taxable bonds backed by letters of credit from major
banks. The letters of credit allow underwriters to securitize the bonds
and sell them to the public. When the underwriters accumulate enough
capital, they can sell the bonds to large money market funds.
Underwriters specializing in these transactions typically manage a
large volume of bonds to help keep underwriting costs low. Many banks
and large securities firms also issue VRDNs.
Issuers
calculate the effective rate of a VRDN issue by adding the London
interbank offered rate, or LIBOR, to approximately 1.3 percent of
annual fees, which include 1 percent letter of credit fee, 0.125
percent remarketing fee, and 0.170 percent bank and rating agency fees.
Thus, if the LIBOR rate is 1.2 percent, the VRDN rate would be
approximately 2.5 percent. Compared to a current prime rate of
approximately 4 percent, the VRDN offers interest rate savings of at
least 1.5 percent.
LIBOR rates are
variable, so risk-averse individuals can purchase a cap to provide a
ceiling on their loan's interest rate. However, the 10-year average for
taxable floating
rates is less than 5 percent. (See chart, "Floating Rate vs. Average Prime.")
Lenders
usually issue VRDNs to small borrowers for five-year periods. At their
option, lenders or underwriters may extend the loan maturity without
additional fees.
Tax-exempt debt
issuance restrictions do not apply to VRDN loans because this is a
taxable securities financing program. Likewise, VRDNs have no public
conduit issuers, such as an industrial development board or a public
housing authority.
VRDN vs. Bank Loan Case Study
A refinancing example illustrates the interest cost savings derived through a VRDN.
The
property had an existing five-year, 7.5 percent fixed-rate bank loan
with a 20-year amortization. After examining LIBOR's 10-year interest
rate history, the developer decided to refinance with a VRDN and was
able to obtain a 2.5 percent cost of capital. The developer needed
additional funds for an expansion of the property, so the issuer made
an interest-only loan for the first 18 months, followed by 
a
20-year amortization with a five-year maturity. By using the VRDN, the
developer saves more than $248,000 annually over the bank loan. (See
chart, "VRDN vs. Traditional Financing.")
Sophisticated
commercial real estate developers and investors quickly are learning
that variable-rate bonds have several advantages over fixed-rate deals.
The large interest rate savings combined with the ability to cap the
interest rate or hedge against an interest rate increase with a rate
swap affords options beneficial to rapidly changing economic
conditions. Variable-rate taxable bond financing also allows small
investors to participate in low-rate financing previously unavailable
to them.