Financing Focus

VRDN Value

Variable rate demand notes allow small borrowers access to the public debt market.

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.

C. William Barnhill, CCIM, and John B. Mazyck

C. William Barnhill, CCIM, is president of Omega Properties in Mobile, Ala. Contact him at (251) 432-1287 or John B. Mazyck is vice president of Merchant Capital LLC in Montgomery, Ala. Contact him at (334) 834-5100 or


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