Accounting
Real Estate Finance and Investment
FIN549
Leverage
Loan Docs
Structuring
Agenda C O U R S E O B J E C T I V E
Class #5
Leverage
Need to understand the fundamentals of the real estate business before you can select the appropriate financing structure. If you do not understand the risks and opportunities of a property, you will never be able to efficiently select your financial structure.
L E V E R A G E
Introduction to Financial Leverage
What is financial leverage? Benefit of borrowing at a lower interest rate than the rate of return on the property.
Why use financial leverage? There are diversification benefits that come from investing less equity. One can buy additional properties.
Mortgage interest tax benefit.
Magnify returns if the return on the property exceeds the cost of debt.
L E V E R A G E
Summary
Positive leverage means that the property cash flow yield (NOI after standard reserves) is greater than the interest rate paid to the lender.
Negative leverage means that the property cash flow yield is less than the interest rate paid to the lender.
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Leverage Topics
Bank, Permanent, CMBS, Alternative (Seller, Hard Money, Debt Funds)
Secured and Unsecured, Line of Credit, Term note, Letter of credit
Amortization
Sourcing
Sponsorship evaluation: Credit / Credit score, Net worth, Liquidity, Experience, Income
Project evaluation: “The 5 C’s”
Ratio analysis
Note, Mortgage key provisions
Covenants, positive and negative
Typical process
Types of Financing and Why
Lender Evaluation
Loan Documents and Process
L E V E R A G E
Why would someone choose to use debt?
You do not have sufficient cash to cover the full cost of acquiring or development. Real estate is capital intensive. Debt allows you to buy or build real estate that you can otherwise not afford solely with your own money.
To diversify your investments
To enjoy the interest tax shield
To enhance your equity returns
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L E V E R A G E
At least 3 times in the last 35 years, real estate has failed to meet the stress test of maintaining equity value when financed in excess of 55% to 65% LTV, yet the industry continually strives to achieve higher leverage levels and is surprised each time extreme economic and capital market distress wipes out large numbers of equity holders and their lenders.
Over Leverage L E V E R A G E
SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041
Debt can be used by the owner of real estate as a tool to enhance returns or (at the extreme levels) to serve as a “stop loss” to limit the amount of equity capital exposed to a particular property.
These benefits come at a cost, however, since leverage can accelerate and magnify the severity of capital loss if the property value declines.
The following cases demonstrate the accelerating impact of leverage on returns under different scenarios of property performance. The scenarios represent two points in time: the inception of the investment, and the liquidation.
Technical Note on Financial Leverage in Real Estate
L E V E R A G E
Case #1
No Leverage.
Without leverage, the investment performance of the equity matches that of the property
SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041
L E V E R A G E
Case #2
Leverage.
Instead of investing $100 in equity, the property is capitalized with $50 debt and $50 equity (1:1).
SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041
L E V E R A G E
SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041
Case #3
67% Leverage.
The property is capitalized with $67 debt and $33 equity (2:1).
L E V E R A G E
SOURCE: Technical Note on Financial Leverage in Real Estate – Harvard Business School April 2,2012, Charles F. Wu, Arthur I Segel, Reference 9-208-041
L E V E R A G E
Case #4 Impact on Mezzanine Debt: An alternative form of equity investing is done in the form of mezzanine debt. Here, the investor takes a “horizontal slice” of the capital stack. By doing so, the investor can achieve equity-like returns in the upside, with downside protection in the (moderate) downside case. A traditional “mezz debt” structure would involve investing in the trance of the capital structure that represents 60%-80% of the property value, in return for an interest rate coupon of plus 50% of the asset’s appreciation. The mezz debt capital is at risk only if the property value declines by more than 20%.
An unsecured loan is supported by the borrower’s cash flow, but does not include a specific lien on the asset.
A secured loan is supported by the borrower’s cash flow and also grants the lender a priority claim to the specific asset as additional security for the loan.
Letters of credit and third-party guaranties are other types of credit enhancements and both of these may also be secured or unsecured.
Security: Collateral and Sponsorship L E V E R A G E
Non Recourse…really non recourse?
Standing offer to put the property to lender in non recourse
Completion Guaranty
Bad Boy – fraud, theft, environmental
L E V E R A G E
L E V E R A G E
What objectives are most important to you as well as to determine the risk return profile Value have risen substantially - access trapped liquidity Interest rates have fallen Position for future / optimal time When cost of equity and cost of debt are the same…
Refinance Reasons
Loan Docs
Laser Pro Documents (“off the shelf”) versus attorney drafted.
Deposit for third parties – bank’s legal and due diligence costs are typically borne by the borrower.
Documentation
Promissory Note
Mortgage Instrument
Loan Agreement
Other
L O A N D O C S
Promissory Note
Typically are short documents that refer and incorporate information in a business loan agreement; the promissory note heavily favors the lender instead of the issuer of the note (the borrower).
Borrower signs the promissory note, but the loan agreement is signed by both the lender and the borrower; as the lender is not a party to the promissory note, it does not have any obligations it would otherwise have in a loan agreement (such as obligations to mitigate damages, act reasonably, or provide certain notices).
The borrower undertakes all obligations under the promissory note: such as promise to pay a monthly amount or the entire loan on demand or at certain times.
Promissory note is a liquid asset and can be negotiated by the lender (transferred or sold). Under many jurisdictions, the rights and obligations provided under a promissory note are easier to enforce than those provided under a loan agreement.
L O A N D O C S
Note Components
• Amount borrowed • Rate of interest • Dollar amount, due dates, and number of
payments • Maturity date • Reference to security for the loan • Application of payments • Default • Penalties for late payment and forbearance
provisions
• Prepayment conditions • Provisions for unscheduled (early) payments • Notification of default and acceleration clause • Nonrecourse clause
Note that even if there is a nonrecourse clause, loans are generally with “recourse” if the “bad boy” provisions are violated. This could include fraud or misrepresentation. Another example would be if the borrower willfully damages the asset, the borrower will generally be held personally responsible for the damage.
• Loan assumability
• Assignment clause
• Future advances
• Release of lien by lender
Evidence of Debt Major Provisions
L O A N D O C S
The Mortgage Instrument
Note & Mortgage • The note and the mortgage are not the same thing
• Note: Obligation to pay
• Mortgage: Pledges property as security
The mortgagor is the borrower. The mortgagee is the lender.
This is often confused by people who are new to the industry.
L O A N D O C S
Loan Agreement
The loan agreement will contain the majority of the obligor/creditor language.
Features include: • Definitions • Mechanics – ie spells draw features if a
construction or draw note • Representations and Warranties • Affirmative and Negative Covenants • Events of Default • Casualty and Condemnation
L O A N D O C S
Other Loan Docs
Corporate Resolutions
Subordination Agreement, Intercreditor Agreement
Assignment Agreement, Pledge Agreement
Disbursing Agreement
Guaranty
Security Agreement; Deposit Account Control Agreement
Disclosures
L O A N D O C S
Loan-to-Value – The principal amount of the loan divided by the collateral value.
Debt Yield – The property NOI divided by the loan amount.
Interest Coverage Ratio – The property NOI divided by the annual interest payment.
Debt Service Coverage Ratio – The property NOI divided by the annual debt service payment.
Fixed Charges Ratio – The property NOI divided by all fixed charges incurred annually.
Five Key Lender Ratios
L O A N D O C S
The fixed charges ratio allows the lender to understand what type of position the borrower will be in given his existing commitments.
Most Conservative Lender Ratio L O A N D O C S
Lender may require provides copies of all new pending leases prior to execution
Lenders focus on quality
Lenders may require that the building be leased to tenants of a specified minimum credit quality or make considerations accordingly
The more risk, the more control / structure features the lender will require
L O A N D O C S
Key Loan Sizing Ratios
Loan-to-Value (LTV)
• Principal amount / appraised value
• 50%-70%
Loan-to-Cost (LTC) – based on eligible loan costs
• Principal amount / eligible loan costs
• 55%-70%
Debt yield
• NOI /principal amount
• 8%-13%
Debt Service Coverage Ratio (DSCR)
• NOI / annual debt service including amortization
• 1.2x and greater
L O A N D O C S
Other Key Loan Terms
Loan Covenants
Negative – things you cannot do
Positive – things you must do
L O A N D O C S
Common Negative Covenants Prepayment penalty
Distributions
Operating restrictions
Additional debt
Common Positive Covenants Deposits
EBIT, Cash Flow, or NOI
Leases
L O A N D O C S
Covenants
Capital Structuring
Change in building value will occur regardless of debt
• Values do not always go up
Residual value after debt
• Impact of varying debt amounts on return of and to equity
Debt is a friend on the way up and an enemy on the way down
Equity return from capital appreciation = (residual value at sale – original equity invested)/original equity invested
L O A N D O C S
Positive and Negative Leverage
Positive leverage means that the property cash flow yield % (NOI after standard reserves / Purchase Price) is greater than the interest rate paid to the lender.
Negative leverage means that the property cash flow yield % is less than the interest rate paid to the lender.
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Structuring
Partnership Structure
The correspondences related to this investment, including the attachments, are for prospective qualified and accredited investors. While the source of all content supplied herein has been provided from sources believed reliable, Altus and its affiliates cannot guarantee its accuracy or completeness. This investment involves certain risks. It must be recognized that other risks, not foreseen, may present themselves in the future and that the risks which are foreseen, may affect to a greater extent or in a manner not now contemplated. Prospective investors should carefully consider, among other things, the risk factors and speculative factors as enumerated in the materials.
Project Level Entity
Member Entity
Sponsor Member Co-Investment
OUTSIDE MEMBERSDebt Financing
Asset 100% Owned
Provides 100% of Equity
Altus controlled entity Minimum ~35% of project
equity
Sponsor Manager
Altus controlled entity
Sponsor to accept recourse obligations
En tit
y M
an ag
er
Entity Member
S T R U C T U R I N G
Partnership Alignment Features
The correspondences related to this investment, including the attachments, are for prospective qualified and accredited investors. While the source of all content supplied herein has been provided from sources believed reliable, Altus and its affiliates cannot guarantee its accuracy or completeness. This investment involves certain risks. It must be recognized that other risks, not foreseen, may present themselves in the future and that the risks which are foreseen, may affect to a greater extent or in a manner not now contemplated. Prospective investors should carefully consider, among other things, the risk factors and speculative factors as enumerated in the materials.
Altus believes the Project Partnership Structure provides investors (including Sponsor Member) with many best-in-market alignment features to ensure Sponsor Manager is continually incentivized to protect Member capital, and deliver optimal risk-adjusted returns, over both short and long term durations. Said alignment features are summarized as follows:
S T R U C T U R I N G
Significant Sponsor Member Co-Investment ~35% Minimum Sponsor Member Co-Investment – Shoulder-To-Shoulder with Outside Members.
Front Loaded Sponsor Member Co-Investment Sponsor Member Co-Investment Front Loaded – Mitigates development risks ahead of Outside Members.
Sponsor Manager Accepts Recourse Sponsor Manager takes on the required recourse risks associated with debt financing without charging Recourse Fee.
Aligned Waterfall Structure Between Sponsor and Members Members receive yield protection through a preferred return hurdle on invested capital (6.0% per year). The preferred return accrues during the construction period and begins payment upon stabilization. Moreover, the Sponsor Manager does not participate in cash flows until 100% fulfillment of the annual preferred return and return on Member invested capital.
Organizational Forms
Sole Proprietorship
Partnerships
• General partnership
• Limited partnership (“LP”)
• Limited liability partnership (“LLP”)
Limited liability company (“LLC”)
Corporations
C Corporation
S Corporation
• No more than 100 shareholders
• No corporations as shareholders (shareholders must be individual persons)
• No nonresident alien investors
• No more than one class of stock
S T R U C T U R I N G
Joint Ventures
Risk Sharing
Combine expertise with capital
• Developer/operator/sponsor
• Investor
Speculative objectives
Organizational Forms
Profit Sharing
• Initial and additional capital
• Share in cash flow
• Share in sale
• Preferred return?
• Taxable allocation of income and loss
• Control operations and decisions
S T R U C T U R I N G
Initial Capital Contributions
The money partner may put up 90 to 95 percent of the money. The developer/manager may put up 5 to 10 percent.
The key concept here is that the developer/manager needs to put up something so there is an alignment of interests.
S T R U C T U R I N G
Sharing Cash Flow from Operations
In Proportion
• Pari-Passu distribution
Preferred Distribution
• Preferred Return
• Disproportionate sharing
• Cumulative versus non-cumulative
• Promote
Specified Fees
S T R U C T U R I N G
Sharing of Cash Flow from Sale
Repay any debt
Return of initial investment (if not repaid previously)
Remainder Distributed
• Predetermined portions
• IRR Preference
• IRR Lookback
S T R U C T U R I N G
A P P E N D I X
Loan Docs - Appendix
DSC Fine Print Matters
Debt Service Coverage Ratio shall mean, for the twelve (12) month period prior to the date of calculation, the ratio of Operating Cash Flow to Debt Service.
Operating Cash Flow shall mean, during any calculation period, all Gross Revenues actually received in the applicable calculation period arising from the ownership and operation of the Property less the sum of all Operating Expenses for the same period.
Sounds simple and straight forward…
A P P E N D I X
Revenue – does it include MTM leases? What about condemnation proceeds? What about lease buyouts? What about leases inked but the tenant hasn’t taken occupancy? Or has taken occupancy and is in a free rent period?
What about the differences in asset classes? Multi family DSC is treated differently?
How are revenues calculated example: “in the event that the average occupancy of the Property over the twelve (12) months period prior to the date of calculation drops below ninety-two percent (92%), Gross Revenues shall be calculated based on the annualized rental for the 12 month period subsequent to the date of calculation of actual leases in place as shown on the most current Rent Roll on the date of calculation, plus annualized rental under signed leases which provide for rental to begin within the twelve (12) month period subsequent to the date of calculation.
DSC Fine Print Matters A P P E N D I X
Operating Expenses shall mean costs, taxes, expenses and disbursements in connection with the leasing, management, operation, maintenance and repair of the Property, including a replacement reserve of $0.20 per square foot and a management fee of the greater of the actual fee or three percent (3%) of Gross Revenues. Operating Expenses shall exclude (i) non-cash expenses, such as depreciation and amortization costs, (ii) state and federal income taxes, (iii) capital expenditures determined in accordance with Accounting Principles, and (iv) Debt Service payable on the Loan.
DSC Fine Print Matters A P P E N D I X
Debt Service shall mean the payments of principal and interest that were due payable on the Loan during the period referred to above, assuming required monthly principal and interest payments that would be necessary to fully amortize the Loan over a thirty (30) year period at an interest rate per annum equal to the greater of (i) the then highest applicable Interest Rate; (ii) six percent (6.0%) percent per annum or (iii) two hundred fifty (250) basis points in excess of the rate of ten year United States Treasury Notes as published in The Wall Street Journal on the fifteenth (15th) day preceding the determination of Debt Service Coverage Ratio.
How is debt service calculated? Understanding that part of the ratio is seldom straight forward.
DSC Fine Print Matters A P P E N D I X
Option 1: Borrower shall deposit funds with Lender in an amount which equals the amount of principal and interest payments calculated by Lender to be due under Note A and Note B during the twelve (12) month period following such default based on the then principal balance due (and in such event, 1/12th of the amount in such account shall be applied each month towards payments of principal and interest then due B until the balance in such account equals zero or such account is released to Borrower.
Option 2: Borrower shall deposit funds with Lender in an amount, which when subtracted from the aggregate principal balance at such time, the result of which would be a principal amount which would produce Debt Service which would meet the minimum Debt Service Coverage Ratio. Such amounts shall be deposited into an account in the name of Borrower with Lender within thirty (30) days following such failure and shall be pledged to Lender as additional security for the Indebtedness pursuant to a pledge agreement in form and substance satisfactory to the Lender in the Lender’s reasonable discretion.
DSC Cure “Ideas” A P P E N D I X
Market Study and Appraisal
Borrower Financials
• Nonrecourse clause. If nonrecourse, it’s sort of like the loan has a built in put option for the borrower.
The Loan to Value Ratio
The Debt Coverage Ratio
Debt Yield
Underwriting Loans on Income Properties A P P E N D I X
Lockout Clause
• Prohibits prepayment of loan for a specified period of time
Yield Maintenance Fee
• Guarantees a yield to the lender after a lockout period expires
Sometimes the fee is fixed as a percentage of the outstanding balance.
This percentage may also vary based on the remaining term of the mortgage.
Underwriting Loans on Income Properties A P P E N D I X
Existing debt may or may not be assumable
Loan covenants
Equity kicker
Prepayment penalty
Interest rate risk – Fixed versus floating rate
Interest rate hedge products – pros and cons
Loan Documents A P P E N D I X
Draws
Amortization
Insurance
Sweep
Secured
Recourse
Guarantees
Receivables
Term
Loan Terms A P P E N D I X
Fees for originating the loan
30-100 basis points of the loan size
Paid at loan closing
Loan Points A P P E N D I X
Replacing one debt facility with another
May entail fees and prepayment penalties
Reasons to refinance:
• Cash out excess loan proceeds
• Mortgage interest rates
• Increase in property value allows you to borrow more (and take have fallen relative to existing rate
The Refi Decision A P P E N D I X
Prepayment Penalties
Sliding scale %-based
Defeasance
Yield Maintenance
A P P E N D I X
30/ 360 = 0.0833 daily equivalent rate. Nominal interest rate / 360
Actual / 365
Actual / 360 … most expensive to borrower
Interest Calculation Bases A P P E N D I X
Reporting
Covenants - Debt Service Coverage or Debt Yield
Lease approvals
Draw process and procedure
Deal Abstracts A P P E N D I X