With record low interests rates a thing of the past, record inflation being more than a transient concern, and real estate valuations falling, borrowers are struggling to raise the capital required to satisfy lower loan-to-value (“LTV”) requirements imposed by lenders as they tighten their credit underwriting standards. This creates intense pressure on borrowers whose livelihoods are dependent on financing and availability of capital. This pressure has resulted in many borrowers requesting lenders approve alternative loan structures that were not needed or sought when economic facts were more favorable. The prevalent economic uncertainty also results in lenders experiencing intense pressure as they are torn between satisfying their needs for loan volume and providing a return for their investors, and the need to properly underwrite loans to mitigate risk to their investors. The tension between these competing forces is high and will likely increase as interest rates continue to rise, inflation batters consumers, and the housing market continues to cool.
In the recent past, when properties experienced record price appreciation and interest rates were at all- time lows, borrowers had little trouble convincing lenders to fund loans. Borrowers had properties with high valuations that could be sold or refinanced with little thought. Under these circumstances lenders had no problem envisioning an “exit strategy” that would always result in their repayment. After all, properties had little trouble selling, with most selling for higher than listing price, and a host of lenders were always available to provide take out financing. More recently, lenders have begun to question the availability of exit strategies and are giving more thought to how they will be repaid when a loan matures. Borrowers and lenders are entertaining alternative loan structures as possible solutions to the problems recent economic times have caused for both borrowers and lenders. Below are brief descriptions of some of the alternative loan structures that are more frequently being sought by borrowers and approved by lender.
The first and most obvious alternative loan structure is for a borrower to provide a lender with more than one real property as collateral for a loan. When economic conditions were less stressful, most loans were underwritten based on a single piece of real property serving as collateral. Today, with real property valuations falling, a single property may not provide a sufficient equity cushion to satisfy tightening LTV requirements. One solution to this problem is for a borrower to offer multiple pieces of property as collateral where the combined values of the properties are aggregated to determine the overall LTV and the equity in the transaction. In most cases this is the best solution. However, before moving forward with a cross-collateralized loan, a lender should be careful to ensure each property is owned or controlled by the borrower and that the borrower has the authority to pledge all properties as collateral for the loan. Lenders will also have to carefully review title work for each property to ensure each property is not encumbered by a senior lien. If a property is encumbered with a senior lien that will not be paid off at closing, a lender will have to determine if the senior lender will have to consent to a junior lien or if a subordination or intercreditor agreement is warranted. Cross collateralization can also be achieved if a borrower has sufficient personal property collateral to support the loan such as accounts receivables. A lender will have to understand the nuances involved in assigning a valuation to such assets.
Seller Carryback Financing
Not all borrowers own multiple properties that can be pledged as collateral for a loan. With real estate markets slowing, property sellers are more frequently offering their own financing to help facilitate property sales. Seller carryback financing involves a property seller financing a portion of the sales price of the property. This financing will generally be secured by a deed of trust or mortgage on the property and involve an actual transfer of the property from the seller to the buyer at closing. In many instances, sellers are providing below market rate financing terms that are attractive to buyers. If seller financing does not cover the entire purchase price of the property, a third-party lender will often be asked to provide financing to bridge the gap between the property’s purchase price and the amount of seller financing provided to the buyer. In these transactions, a lender will likely require the seller financing to be subordinate to the lender’s loan. Once subordinated, the lender can exclude the seller financing when calculating the LTV for the loan. One major pitfall that lenders should avoid in these financings is not fully understanding the terms of the seller financing. Specifically, a lender should know if (a) the seller financing will mature prior to the maturity date of the senior loan, (b) the seller will agree to be in a subordinate position, and (c) the seller’s financing terms include any restrictions on the use of the property or contain any reversionary rights to the property that enable the seller to recover the property if the buyer fails to satisfy certain conditions? Another pitfall lenders should be concerned with is the fact subordinate seller financing can present an illusory impression of borrower equity in a transaction. Lenders should remember that though treated as equity, subordinate seller financing is not actual equity injected into a project by the borrower. It is just more debt secured by the property. This additional debt could be an impediment to a borrower’s ability to sell the property or refinance the property. As property valuation continue to fall, this problem could be exacerbated.
Another structure sought by capital starved borrower is mezzanine financing or “Mezz Financing”. Mezz financing is a form of debt that permits a borrower to raise capital without encumbering the real property with a lien. A lender can permit a borrower to fill its capital stack while retaining an exclusive senior lien on its real property collateral. In typical mezzanine financings, the mezz lender provides a loan to the entity that owns the membership interests of the entity that directly owns the real property (the “Project Owner”). The mezz loan is secured by an ownership pledge of the mezzanine borrower’s ownership interests in the Project Borrower and not by a lien or other encumbrance on the underlying real property. At no time will a mezzanine lender receive a lien on the real estate that is pledged to the senior lender by the Project Owner. These loans benefit all parties with an inflow of additional capital to support a project. The senior lender reaps the added benefit of a lower LTV and not having a competing lien on the real property. Mezzanine loans are complicated loan structures that involve substantial legal costs to draft and negotiate the mezzanine loan documents and an intercreditor agreement between the senior lender and the mezzanine lender.
The alternative transactions listed above are just a fraction of the potential loan structures lenders will be asked to fund as borrowers grapple with the end of an era of generous credit terms. Lenders should not shy away from entertaining alternative loan structures just because they are new to the lender. While doing so, lenders will need to weigh the risks associated with a proposed alternative loan structure against the risks associated with such structure. If a lender is able to get comfortable with alternative loan structures and appropriately underwrite their risks, they may find a deep pool of deals it can tap into and gain a competitive advantage over its competitors.
Still have questions? Contact the Geraci LLP transactional team to ensure you and your investment are protected.