Leverage: A Tactical Guide to Lender Finance

Kevin Kim:

Let's get started. Welcome everyone to the webinar. My name is Kevin Kim. I am a partner here at Geraci. I lead the firm's corporate and securities team, and we are about to start a webinar called Brace for Impact Leverage, a tactical guide to Lender Finance. Joining us today are two of my esteemed colleagues, two gentlemen I look up to. They work on a ton of these transactions on behalf of our clients, and so I'll let them introduce ourselves. Tom, you want to go first?

Tom Hajda:

Yeah, my name's Tom Hajda Of Council with the firm, and I work on the more sophisticated transactions on behalf of the firm, including assisting clients with leveraged transactions.

Darren Roman:

Hi, I'm Darren Roman. I'm a senior attorney with the firm. I also like to work on senior higher level, more complicated transactions, including the leverage and our warehouse lines of credit.

Kevin Kim:

Alright, so before we get started, guys, a little bit of housekeeping. So first things first with question and answer. We're going to be doing them in the q and a feature in your zoom below. So please type in your questions and we'll get to them later in the webinar when we have the section four q and a. Another thing is going to be this webinar will be available for viewing on our YouTube channel, and the slides will be available for you on our website, Geracilawfirm.com. So please, you will be able to find it after the webinar. It'll be available for your listening pleasure later down the line. And then lastly, I wanted to remind everyone about Geraci's upcoming conference in April, April 17th through the 18th, the fabulous Innovate Conference at the wonderful Balboa Bay Resort here in Newport Beach, California. If you haven't signed up, please do so already.

We really want to see you there. So let's get started. This webinar today, we're going to discuss something that's very, very important to, I guess all private lenders, but also particularly to debt fund managers, which is why I'm here on the panel. We're going to be talking about leverage and what is leverage, and particularly lender finance. And we're going to get into some basics, explain the mechanics. We're going to get into the qualifications for some of these programs and really go into the ins and outs of the negotiation process and the terms to look out for. And then finally, going to get into some maintenance issues and things that can go wrong for you as the borrower when it comes to these transactions. So that's the agenda for today. So let's get the ball rolling and get this webinar started. So first question we have here is basically what is leverage?

What do we mean by leverage when it comes to the private lending industry? Not leverage about the loans that you give your borrowers, but leverage that we're taking as lenders, as private lenders. So I basically guide, I'm going to be moderating this panel, but Darren and Tom are going to be leading the conversation. So to take it away guys, so let's kind get into it. There are all types of different programs out there. You've got general lender, finance, warehouse, lines of credit, credit facilities, repo lines. I've heard all kinds of different working capital lines. I heard all kinds of different programs that exist out there. What are these programs and what are the differences? And give us a kind of basic explanation there.

Tom Hajda:

Yeah, so I'll go ahead and start. So leverage can be something as simple as I have a few clients who have a group of friends and family that provide money to the lender and they turn around and use those funds to make loans to their borrowers. Oftentimes, the money's provided without any type of agreement. We won't really be spending any time talking about that, but that's certainly out there in the marketplace. A less sophisticated form of leverage could come in the form of hypothecation. And I think the easiest way to describe hypothecation is maybe to give you an example. So if I make a $500,000 loan to Darren, I can get leverage by getting a loan from Kevin. So if Kevin's going to finance 400,000 of the 500,000 loan that I give to Darren, Kevin gives me a loan for 400,000 and his loan is secured by the loan that I give to Darren. I've also seen with some clients, they issue a series of notes to investors. They raise funds through the issuance of those notes to a pool of investors, and they're secured by a pool of mortgage loans originated from the funds, raised from the notes. And Kevin, I don't know if there's anything really in your area that's important to discuss at this point with respect to the note investors.

Kevin Kim:

Effectively, the only consideration to have when you're doing those types of note investor funded note programs is going to be you've got securities considerations to think through. Right? So that's important. That's about it.

Tom Hajda:

Okay. One type of leverage and perhaps the most popular that I've come across with our clients are warehouse lines of credit and warehouse line of credit is simply a revolving line of credit, and I'll use some defined terms here to make it easier to discuss. So you have a warehouse lender, which is very often a bank that makes revolving loans called advances to a warehouse borrower. So the warehouse borrower uses the funds from the advances to make what are called collateral loans to the warehouse borrowers, collateral borrowers, and I call them collateral loans and collateral borrowers because the loans made by the warehouse lender are serving as security for the advances that the warehouse lender gives the warehouse borrower. Very often the warehouse line might also be secure by other assets of the warehouse, borrower and the parent of the warehouse borrower may pledge its equity in the borrower's additional collateral for the line, and we will talk more about the later. The last form of leverage that I tend to see a lot with our clients take the form of a master repurchase agreement.

And essentially a master repo transaction is a warehouse line of credit that's that's structured as a loan sale transaction instead of a credit transaction. So you have a repo buyer, which is the equivalent of a warehouse lender that purchases loans from the repo seller, which is the equivalent of a warehouse borrower. The repo seller is obligated to repurchase loans from the repo seller, and the repurchase price includes an imputed interest called a price differential. So the biggest advantage to a master repurchase agreement over a warehouse line of credit from the lender or the repo buyer's standpoint is that the repo buyer enjoys protection under the bankruptcy save harbor. So if the repo seller were to go into bankruptcy or file bankruptcy, the mortgage loan sold by the repo seller to the repo buyer would not be included in the repo seller's bankruptcy estate. And this saves the repo buyer a lot of time and money, which makes it a fairly popular form of leverage for larger banks in connection with larger transactions. One interesting fact is that the master repurchase agreements are treated differently from a bankruptcy versus an accounting and tax purpose. So it's treated as a sale transaction for purposes of the repo buyer's bankruptcy protection, but it's treated as a loan for accounting and tax purposes, which really gives the repo buyer the best of both worlds.

Kevin Kim:

Great. And I guess one of the key things to think about is why does a private lender ultimately care about these lender finance programs? A lot of folks on this webinar clearly are educated to know more want these kind of facilities, but for the new uninitiated private lender, why would I want something like this?

Darren Roman:

I'll take this one, Kevin, can you hear me all right? Yeah, sure. So I think the best answer for that is it gives you access to more capital than what you would have normally. These lines of credit, they can range from 20 million upwards of $200 million, and it's just more money that's available for the lender to put out there on the street. They basically take the money from the warehouse line and they make loans that increase their fees and their revenues with capital that they just wouldn't have otherwise if they were raising it in another form. So it is just a way basically to leverage up their business and to scale up their business when they might not otherwise be able to do so by using more traditional sources of capital.

Kevin Kim:

Agreed. Fantastic. And also the interesting thought process there is, well, depending on what the rate is, right? The idea of you get yield enhancement by virtue of the delta of the loan, what interest rate your borrowers paying and what you're paying to the bank or to the lender. So that's a nice little added feature provided that the rate is low enough.

Darren Roman:

We'll talk about arbitrage in a little

Kevin Kim:

Bit. Exactly. All right, so let's move on. So the next thing here to talk about is talking about really the mechanics. So a lot of times people, various programs are different, but the fundamental precept, the lender finance and leverage, there's a component in which they're lending you money. We understand that, but understanding how one can draw on this, it's usually a line of credit. So how does it work when it comes to drawing money? What are the usual terms that are out there when it comes to those limitations? And then what's the actual step-by-step method in which a lender say, Hey, all right, I'm going to borrow a warehouse line of credit from x, y, z bank. What is the actual step-by-step method in which the borrower now can draw on this line when it comes to when he needs that capital? Right? So what do you think guys?

Tom Hajda:

Well, maybe we'll start with the concept of advance rates. So as a warehouse borrower, I'm going to take down in advance and then make a loan to my borrower. So let's say that I want to make a million dollar loan to Darren, so I may draw down an $800,000 advance to help fund that loan. And the $800,000 advance in this example is 80% of the loan that I'm making. So it's considered an 80% advance rate. And different warehouse lenders have different advance rates and advance rates are very often determined by the lesser of the underlying collateral loan amount and the value of the property. And so what I've seen today in recent warehouse lines is that the warehouse lender slender may make an advance equal to the lesser of anywhere from 70 to 90% of the principal amount of the underlying loan, and anywhere from 55 to 70% of the value of the mortgage property securing that loan. So when you're making advances, you're not going to pull down a million dollar advance to fund a million dollar loan. It's going to be some lesser percentage to protect the lender. Darren, you want to talk about arbitrage?

Darren Roman:

Sure. Let me just follow up one thing, and Tom was talking about on advance rates is what we're seeing in the marketplace. Advance rates seem to be tightening up a little bit as credit markets tighten the economy, some uncertainty, everything the lenders might be pulling back a little bit. It's no different than what the lenders on this, the funds when they pull back and they reduce some of their advance rates. If you're doing a construction loan, you may have gone to 85 or 90% loan the cost before, but now you might think, oh, maybe 75% is a little bit more comfortable. So we are seeing that. So that's just something everyone has to take into consideration when they're getting into these lines of credit. But the arbitrage is one of the most important things when considering one of these lines, because you are borrowing funds, it's your cost of capital, and what you need to do is make sure that you're borrowing at a low enough rate that you can turn around and take that money, borrow it, and then put it out to your borrowers, and that your cost of capital will not exceed the rate at which you can lend.

So you don't want to borrow a 10 if you can only make loans at 8%. You want to be able to borrow seven to 8% and put your loans out there, maybe 10, 12% in that range. So you can make the difference. You are borrowing the funds, you do have to pay it back, so you rely on your borrowers to repay you. So that interest rate that comes in that spread is going to be going to impact your profit margin. Right. And the follow up question

Kevin Kim:

For you guys is, I mean the general, I guess pricing arrangements that we're seeing haven't changed, but because they're adjustable, they've come up clearly with fed rate increases. Correct?

Darren Roman:

Yeah. I mean, a lot of times the lenders that we represent, the funds and so forth, a lot of their loans are traditionally fixed, but a lot of the warehouse lines have variable rates. So those rates are changing and we know we're in an increasing interest rate environment. So that's another thing also be wary of you want to borrow and not only consider what your rate will be today, but what could it be during the middle of the term of your warehouse facility? Is it going to create a negative arbitrage where you're borrowing at a higher rate than what you would be able to take that money and lend it out, which will cause you to lose money? So that's something to be very mindful of.

Kevin Kim:

And let's talk about the actual mechanics and the process in which, so let's just understanding the way in which a lender will utilize this facility. Let's just assume that someone's got one now, they've gone through the process, but understanding the mechanisms of, well, I've got a loan to fund. What are the kind of things to think about when they want to actually utilize their lines of credit? There are a lot of limitations there, aren't there?

Tom Hajda:

Yeah, there's a whole process set forth in these warehouse line agreements. Typically, and I don't want to get into too much detail, the warehouse borrower will submit a very specific form of borrowing request, and most warehouse lenders require about five business days to take a look at the borrowing request and review the loan documents for the underlying loan that will be funded by the advance or leveraged by the advance. So typically they require, I've seen anywhere from three to seven business days to review that. And there are limits on how much you can ask for. We already talked about advance rates, but as the warehouse line ages, the warehouse borrower needs to think about, well, what's really the maximum credit limit on the line to make sure that advance won't stick you over, that you don't want to trip over your advance rate or your borrowing base. And your borrowing base is really the aggregate of all of the advance rates to have an overall limit on what you can borrow. So I've seen in most lines, there's a limit on the maximum amount of any single advance, and there are limits in most lines for loans to one borrower. So if you've made advances to Darren on a number of occasions, the warehouse bank may want to limit its exposure into the line to a single collateral borrower. And so they may impose limits on that.

Kevin Kim:

Right. And that package, so one of the things in our space is the industry's kind of split down the middle when it comes to their underwriting guidelines and some run appraisals and some don't. Some run credit, some don't. Right. And banks will likely want some type of documentation when it comes to that. And how does that usually, are you guys aware of what the requirements are with that? Is it a backfill later send in documentation later, or is they have to submit it upon request? How does that usually work?

Darren Roman:

Generally what I've seen is you have to submit that upfront, and a lot of this goes into your pre-negotiations of what would be deemed an eligible collateral loan. You have to negotiate that to make sure it fits the type of transactions that you yourself are funding. So you don't want to negotiate a warehouse line that says you can only do these types of loans when you're doing a totally different type of transaction to your own borrowers that this line would pretty much be unavailable to you. But yeah, a lot of this stuff is negotiated upfront. You got to make sure the definitions of what an eligible loan work with your business model. Otherwise the line just it won't benefit you at that point.

Tom Hajda:

That's a good point. So the warehouse line will define with a lot of specificity what will be an eligible loan for this line, and it will define what kind of borrowers are eligible borrowers, and it can go into a great level of detail. And finally, the agreement will also define what's an eligible mortgaged property, and it may limit it to one to fours. It could include multifamily or commercial. I've seen restrictions on geographies. Most lines require that the property securing the underlying collateral loan be located in an SMSA of a specific population or over.

Kevin Kim:

Good to know. Alright, so one of the things that's been changing over the past few years is the process associated with recording the assignment when it comes to the loan itself, the underlying mortgage. So what is the current, I guess, status quo when it comes to policies and procedures when it comes to these facilities with recording the assignments themselves? So you borrow the money, you drew the money, and they want their collateral, which is your mortgage, right? What's the process there? Is it always recorded nowadays or is it kind of half and half? What's the story there?

Tom Hajda:

That's,

Darren Roman:

Go ahead, Tom.

Tom Hajda:

Oh, okay. Yeah. So that's a really good question. And this is really where you need to talk about assignments and dwell times at the same time. So many of my clients obtain warehouse lines for very short term financings, 30 to 60 days, and it covers the time period from funding the underlying collateral loan to selling that loan to an investor in the secondary market. And typically that's 30, 40, 50 days from time of funding to execution of the sale to a toric or a Churchill or other secondary market investor. And so for these shorter term lines, the warehouse lender very often will not record the AS assignments. They'll get the assignment blank and hold onto it, and if there is a default, they'll record it. But given the very short period of time between funding the advance and getting the advance paid off, it doesn't really justify the expense and the effort to record them. Although I will say with some of the larger banks and larger warehouse lenders, they'll record it no matter how short the dwell period is. And then for longer term dwell times where you might have a warehouse borrower that may want to park their fix and flips on the line for 12 to 24 months, at that point, lenders almost always record the assignment of mortgage. And Darren, maybe you could share why it's important to record that assignment of mortgage from a lender standpoint.

Darren Roman:

So I think that the key here is to remember that the warehouse lender's collateral is not the underlying property. It's the loan. It's the loan, it's the deed of trust, it's the promissory note. The warehouse lenders not have a direct lien on the underlying mortgage property that a fund has made a loan to. They have collateral assignment of the loan documents, the loan, and the payment rights under the promissory note that were made by the fund to the end borrower. So in order to protect themselves, they have to put the world on notice that they have a security interest in this loan. So what they do is they generally, most of the bigger institutions, like Tom said, we'll record those collateral assignments every single time. They don't care. It is just a matter of due course once it's part of the documentation, it's part of the closing process and everything.

Others don't. They wait. They know it's cumbersome to record the release, to record the assign itself. It's cumbersome to record their release of the assignments when the properties ultimately sold to somebody else. Sometimes they get missed and creates a cloud on title, and it's a hassle to get it done going forward. But the real issue for the warehouse is they need to put the world on notice that they have an interest in the loan itself because they do not have a direct via trust. Along the same lines, some of them also require that the original loan documents be sent to them or custodian so they can hold them. Another way they can protect their interest in the promissory notes is that they have custody or control of them because we know promissory notes are instruments that can be assigned. They're almost as good as cash. And so to make sure no one else gets their hand on the instrument has a claim or competing claim for payments on that instrument, they will have, will either hold themselves or required that a custodian hold it. So that's basically from the warehouse lender's perspective, which is not the same as you are making a loan from the fund to the borrower. You get do trust.

Kevin Kim:

I want to go back to dwell times really quick because dwell times are a very material issue and they seem to be dependent on the program itself. So depending on who you're borrowing from when it comes to lender finance. And so Tommy, you mentioned two different types of programs. You have one program where it's purely designed for loan sale, right? It's really there to facilitate the saleable a loan to secondary,

Tom Hajda:

Right?

Kevin Kim:

And the other one is more for warehousing loan on the balance sheet permanently. So our industry has shifted a lot. And so what used to be purely a short-term loan type industry is now shifting toward, they're also doing a lot more, I mean these DSCR loans, these term rental loans in the resi world. And we've even hearing some in the multifamily universe, so do types of assets, are those types of assets eligible for these kinds of programs? Are they completely written off?

Tom Hajda:

Yeah, that's a great point. So going back to some of the shorter term loans like the 12 to 24 a month fix and flip or bridge loans, I used to see principally warehouse lines for short-term funding pending sale in the secondary market. It's no surprise to any of our clients who are listening today that there are many secondary market investors that have slowed or temporarily suspended the purchase of loans in the secondary market. So I've seen actually a number of clients seeking warehouse lines for longer terms because the business models have changed from fund originate, sell, fund, originate, sell to. I need to park this on my balance sheet for a while until I can find an investor to buy it. And so the need for lines has really changed from the short term funding to longer term funding to give the lender a bit another alternative to be able to keep that loan on balance sheet and using the line to do that.

I really have not seen, and Darren, I'll be interested to know what, you've seen a lot of loans where you might have a 15 to 2030 year DSCR rental property loan that's funded with the warehouse line and maintained on the line for a long period of time. Because typically what I've seen is these warehouse lines may have a draw period during which the warehouse borrower can draw down advances anywhere from a year to three years, sometimes a bit longer, and that can be extended, and then there's a fairly short repayment period or perhaps a balloon. So if a lender's going to start financing their DSCR loans with the line, chances are it's going to have to come off the line after a while because the lines will mature. And if the line doesn't get refinanced or extended, then the warehouse bar is going to have to have an exit strategy for those loans. Have you seen any of the DSCR warehouse lines? Darren?

Kevin Kim:

No. Tom, I haven't seen a lot of that, which makes sense. I mean, that product is really designed for the institutional investor to take down and hopefully Securitize or Life Co or whatever. So it makes sense not to be a balance sheet strategy or permanent strategy for a lender at the middle market level. Right. So all right, moving on. So the next slide here, let's talk about qualifying for these programs because a lot of times people, I get this question a lot because my primary role when it comes to client services is primarily managing advising and informing debt funds. And the number one thing that, aside from raising the money, is thinking about leverage and going out and finding a warehouse line. But a lot of questions revolved around basic qualifications, like when should I be speaking with a bank about obtaining one of these programs or non-bank? There are plenty of non-bank programs out there, right? So I want to let you guys talk about this a little bit. This is a very, very common question that we get, and I think our audience would like to know more about this.

Tom Hajda:

Well, I think one of the factors is your lender a bank or is your warehouse lender drawing on funds from a bank? Because there is an extensive due diligence process of a potential warehouse borrower, and it's fairly robust and it takes a long time. One thing to remember, if your prospective warehouse lender is a bank, they're required under bank regulatory requirements to establish credit and risk committees, and they're going to vet the applicant to be a warehouse buyer very carefully, and I won't go into a lot of the factors that the bank looks at, but they need to present a significant document to their chief risk officer identifying credit risk, interest rate, risk, liquidity, price, transaction compliance, strategic and reputation risk. And the reason I mentioned this is that the assessment of these risks by both the bank's risk committee, credit committee, and the bank regulators at the bank, it really informs the manner in which they conduct their due diligence.

So the first thing they're going to do is they're going to look at the financials of the warehouse buyer. They'll look at tangible net worth liquidity, net income leverage ratios, and any number of other financial conditions. And they very often build these financial covenants into the warehouse line. One of the things that I've seen that sets a lot of my clients back on their chair is the bank will ask for policies and procedures from the perspective warehouse borrower, from anything from anti-money laundering, know your customer licensing, state compliance, what are your policies to make sure you comply with state usury, prepayment penalties, late fees and the like. And compliance with federal law. There are a number of federal laws that apply to business purpose mortgage lending. You've got equal credit opportunity Act, fair lending laws, hamda, fcra, and any other numbers. And there most banks will require that you have written policies and procedures outlining these documents.

And there are a number of vendors out in the market from whom you can purchase these policies and procedures. But the important thing to remember is you actually have to follow the procedures and make sure that they relate to your actual underlying operational policies. They're going to ask for the warehouse buyer's underwriting guidelines, and they're going to look very carefully at that. They also look at the loan documents that the warehouse borrower gives to its collateral borrowers. So those of our clients that use the ity loan documents very often find that they can short circuit that facet of the due diligence because many of the banks are familiar with our closing documents, which are fast becoming the market standard. And if they know that the warehouse borrower uses GSI closing documents for their borrowers, they can tick that off the box very quickly. Darren, do you have any other?

Darren Roman:

Yeah, I think there's a couple ways you can get tripped up here in the due diligence created is first and foremost, banks are going to, they're going to look at your balance sheet and your financial statements. So make sure you're certified public accountant is reputable, someone who the banks want confidence in. And then I think in situations where your organizational chart is very complicated and there's multiple layers, just be prepared for the banks to want to see all the organizational documents of every single entity, every single member, every single partner, limited partner, however you structure, they're going to want to see everything because they have to comply with other customer background checks, otherwise they won't be able to open up the accounts and move forward with the warehouse line. And I've seen some borrowers on their warehouse facility reticent to give out some of those documents and it just slows up the process.

Kevin Kim:

I would also to add some stuff here for our listeners, because on the debt fund side, we get a lot of these questions. A lot of people think, they ask me, Kevin, why is the bank asking me if I'm a debt fund or not? And they call me, we want to set up a fund because the bank is asking us to. And the logic behind that is it's a level of comfort for them. For the longer term warehouse lines, they allow you to hold the loans on balance sheet and on the line, it's a level of comfort for them. There are programs out there, there are platforms out there that are like, I don't know, single high net worth, investor funded, venture funded, what have you. Same logic applies. The bank is really trying to look at your liquidity, but also they view it as kind of a part of the blueprint of a avatar borrower for them.

They really like that as the part of the business model, because there's a higher likelihood of sophistication, there's a higher likelihood that you've engaged counsel to manage your compliance. There's also, you're probably going to have audited financials. Many of the more larger programs out there insist on audited financials. And there's also going to be a likelihood of less risk of liquidity because if you have a debt fund, your capital sourcing is going to be derived from a multitude of investors as opposed to a single high net worth investor or a single venture backed company or a single hedge fund, something like that, or that single investor can really just pull out. And then all of a sudden now the bank's at risk. So that also is important to them. And so while I will tell you that not every lender finance finance program out there requires a debt fund, they tend to prefer it for those reasons, but there's always going to be a minimum balance sheet requirement on their end.

They're going to want to make sure that you have a balance sheet. And I don't care if this is a non-bank program run by an institutional investor or a bank itself, a small bank, big bank, regional bank, national bank, doesn't matter. They're going to want to see some kind of minimum balance sheet. And that ranges anywhere from 5 million to 20 million to a hundred million depending on who you are as the bank or the lender. They're going to ask, they're going to insist on that. And on top of that, they're going to want to see that money, that money become deposited with them because they're going to want to make sure they get that right. So that's going to be important to the bank as part of the process of onboarding with them. Let's talk about the next slide here. So really grading through the nitty gritty of the actual negotiation and structuring considerations. Let's go through the different various different fee arrangements. This is where I'm actually very, I don't actually know, but in and out to this, I get a lot of questions of like, I understand what the advance rate's going to be, this market rate, but where are all the fees and how am I going to get charged and am I going to be feed to death by working with a lender, lender finance program? You guys going to get into the weeds on this one a little bit?

Tom Hajda:

Yeah, I guess I'll start on that. So the first chunk of money that's going to be taken out of the height of a warehouse borrower is the lender deposit that's required after the term sheet has been executed. And typically the lender deposit, it's intended to cover the warehouse bank's legal and due diligence costs. And I've seen the deposit really ranging anywhere from 50 to $85,000. And they use that to pay their lawyers to draft the warehouse line documents. And it's also used by the bank in connection with its credit committee and risk committee and the other due diligence participants at the lender. And that amount of money is fully earned. So they typically, even if they deny the credit line after the completion of due diligence, the bar is not going to get that deposit back. And then once the facility has been approved, right before the line is opened, or at the time the line is opened, you're almost always going to see a facility fee. Banks, I would say 90% of the time, charge a facility fee. The non-bank lenders less, and I don't see facility fees for master repurchase agreements. They typically exist in connection with the warehouse line of credit, but those can be anywhere from 35 to 50 basis points and the basis points multiplied by the maximum credit limit. So it can be a fairly steep upfront cost just for making the facility available to the borrower. Darren, you want to talk a little bit more about draw fees and minimum use fees?

Darren Roman:

Sure. Draw fees are just what they sound like every time you do a draw under the facility. There's a small fee associated with the warehouse under funding that advance, they're on some warehouse facilities will have minimal use fees. These are more fees associated with what your balance is because if it's a financial institution, a bank, they have capital requirements, so they're allocating capital to your warehouse line. So if you're not drawing on the warehouse line, they saw capital associated with this. So they're trying to offset some of those costs. They're not large costs for the most point, but sometimes they're charged. Most of the non-banks won't charge them. They don't have the same capital structures. And so if you have an extension, you'll get an extension fee. And also if you have increases in the line, there's going to be an increase there. And of course, always you're going to pay the attorney's fees associated with the warehouse lender revising the documents or making any changes to the structure of your loan.

Kevin Kim:

Alright, so that's some of the fee fee issues to consider. And let's talk about the minimum use and the draw fee concerns there. A lot of people are less, they may have a line, they may be almost ready to finish their docs on online. The issue lately has become this minimum use concept. A lot of folks are less likely to use their line gotten much more expensive. We're looking at what was five and a half, four, 5% is now eight and a half percent. And so in that regard, the issue is, well, I'm only going to use it when I need it. So has that become a more contested issue when it comes to negotiation? And what other terms are being negotiated more heavily when it comes to the terms of the loan documents?

Tom Hajda:

Well, the minimum use fee. So for example, if the warehouse borrower during a calendar month or during a calendar quarter doesn't average of 50% or 40% or 60% usage level, then the bank's going to make them pay interest on a certain base level. So a common provision is if you use less than half, then you have to make up that delta by paying interest even if you haven't used the full half. That used to be very highly contested. But I can tell you the credit boxes have really tightened in the last six months and bank lenders. So I really don't see minimum use fees for the master repurchase agreements with a lot of the non-bank lenders. But with respect to the warehouse lines, it's pretty important to them. And I see it more often and the banks have been, at least in the last 12 months, much less willing to negotiate that economic turn.

Kevin Kim:

All right. So before we get into the question answer, I also want to talk about pitfalls. And so you got your line approved, you're using it and something goes wrong, underlying loan goes into default, it's pledged to the line, something happens internally at the business. What are some common terms of default and what are some of the practical aspects of how the lender finance programs will work with their borrowers when it comes to defaults or defaulted loans? Is it as scary as some people think it is? Right? Are we back, are we worried about the dreaded margin call or the line being called or is it different?

Tom Hajda:

Yeah, so that's a good point. I'll talk about the events of default with respect to specific collateral loans that are securing the warehouse line. And then I'll let Darren talk more about the events to default under the warehouse line itself by the warehouse borrower. So what you're going to see in these warehouse lines is a series of reps and warranties, just like you'd see in a mortgage loan purchase and sale agreement to an investor in the secondary market, you're going to rep and warrant that the loans were originated in accordance with applicable law. They've been enforceable versus lien. They're covered by a property insurance and title insurance that meet the standards in the warehouse line. There's no maturity default with the underlying loan. There's no payment default and any other number. Usually you'll see about 20 to 40 loan level reps and warranties. And so a well-written warehouse line, and Darren and I will always add language if it's not already in there, specifying that a loan level default is not going to trigger an acceleration of the warehouse line. So as a practical matter, a well-written warehouse line is going to read that a breach of a loan level rep will really affect the obligation of the warehouse borrower to take that collateral loan off the line and to repay the advance relating to that defaulted loan or to withdraw that collateral loan in default from being included in the borrowing base.

Kevin Kim:

It's important. And a follow up to that. So what would the mechanics of that actually look like, right? So the underlying loan either has breach reps and warranties, or is actually in default, your underlying borrowers in default. Is the bank going to, how does that process actually look like practically to the client?

Tom Hajda:

Well, warehouse signs will require the warehouse borrower to provide monthly collateral loan reports that include a series of statements verifying that all the loans are satisfying the various reps and warranties. And there are specific reports servicing related reports dealing with the payment. So if an underlying loan, usually what happens is the bank's going to ask and start tracking a loan that's 30 days past due. And as a general matter, once that loan gets 60 days past due, the bank relationship manager will call the warehouse borrower and say, you know what? You need to take this off the line and we're not going to include this in your borrowing base. So you need to pay your line down by a certain amount. Now, if there's a massive series of defaults by a number of loans under the line, that may trigger a larger acceleration default under the line.

Kevin Kim:

And this is why we have the note here that not all banks are created equal. That you want to make sure you're working with a bank that has a lot of experience in this world and also with this program. And unfortunately, it's very hard to know. A lot of banks have just jumped into this sector. It's a very attractive product from a bank standpoint. And so many, many banks have jumped into offering this product to our sector specifically. And in that regard, do they have the experience and the know-how to manage this process with their clients? Because I'll tell you, some of the more experienced banks, I've been on phone calls that are just very pleasant and very easy to manage, and they call it as it is and say, all right, let's get the loans off the line. Here's the path forward. Give us your path forward. Let's get a game plan going. And very easy to work with. And other ones are much more combative. So I think it's very important for our listeners to think about, it's not just the program itself, it's the quality of the lender that you're working with, much like yourselves, right, with your borrowers. Darren, let's talk about the events of default itself for the borrowers themselves right now. This is now borrower level defaults on the line loan document for the line. Get into that.

Darren Roman:

Sure. So I just want to touch on the last subject just to reiterate, don't panic if a mortgage loan goes into, if it goes into default, it's not the same thing as a default under the warehouse line itself, where the warehouse borrower, meaning the fund misses a payment, reaches the financial covenant, they file for bankruptcy. The borrower actually maybe reaches some of the SPE or bankruptcy remote provisions. Maybe there's a change of control who actually has control of the warehouse borrower. Those are some very typical defaults. The defaults are going to track, honestly, the defaults of a loan agreement. Don't pay all those typical defaults. Don't pay, have liens against your assets, proper bankruptcy and so forth. So as a lender, you should understand already what the defaults are, what you're going to have to do. But these banks, the warehouse lenders have put a lot of time and effort into developing this relationship.

They've put a lot of time and effort into doing the credit underwriting and getting these large facilities approved. So some of the more experienced ones are going to work with you more depending on the nature of the fault, as long as it's not a bankruptcy or you're falling too far behind. But if it's a default that Tom is explaining where it's a collateral loan has gone to default, they're going to be much more flexible. So I guess the bottom line is don't put yourself in default by your actions. It's a little bit more easier to deal with if it's one of your borrowers going into default under the facility.

Kevin Kim:

Right. I also want to stress to folks who are listening, depending on the program, if it's a bank, but I guess you can call it a repo line or long-term or more warehouse facility. And also some of the features that, some of the things that everyone worries about, and this is more of an investor driven conversation, is like, oh, what's the risk of a line being called the dreaded margin call? And aside from these events of default, a lot of people are worried about, oh, we're going to see another 2008 happen. Again, I want everyone to understand these programs are markedly different than the programs that we saw back in the pre-recession. They're non market to market facilities. They're usually designed to be balance sheet driven. But if you do enter into some of the short term dwell lines that are designed for specifically for sale to the secondary, there is going to be a penalty if a loan stays on the line for too long, right, Tom? I think the rate goes up, right?

Tom Hajda:

Absolutely. So really depending on the sophistication of the lender, the borrowing base rate may decline by a specific percentage amount. It may decline every three months that you go over a threshold. And if the loan's been on the line long enough, it may not qualify at all under the borrowing base.

Kevin Kim:

Alright, I think it's time for Q and a. We got some really good questions here. So let's go with the first one here. I think this is a question more for me. What scenario would leverage not trigger UBIT in a debt fund on a K one? So this is actually more of a tax question for our listeners. UBIT stands for unrelated business income tax and in debt funds in the debt fund world. So I'm talking about an LP GP or LLC manager structure, right? Note instruments, not anything else. ubit is generated when you have non-taxable investors a A IRAs 4 0 1 Ks combined with the fund having leverage. And the pure reason why it's generated is because the IRA investor is earning income on capital that doesn't belong to it, right? It's a non-taxable plan. So it's not paying taxes on the earnings generated from the capital in the account, but it will have to pay taxes on earnings generated from capital outside of the account, meaning leverage the bank capital.

So there are a handful of ways. The most common way to block UBIT altogether is to become a mortgage reit. Mortgage REITs will block UBTI completely. There are a few other structural strategies, but they are kind of a gamble depending on what the cost of that leverage is and the impact on the portfolio, the surefire way is to become a mortgage reit. So that's that one. Alright, moving on. We have a series of questions from Mr. Terry Wallman. Thank you very much for your questions. So here's some questions. Here I am. We fund individual mortgage loans, purchase portfolios of mortgages and provide venture finance lending to mortgage loan companies. Q1. What would minimum loan amounts be from these various types of lenders? Warehouse facilities slash repo companies? Yeah, so what are the minimum loan amounts that you see from these various different types of programs

Tom Hajda:

For the warehouse line,

Kevin Kim:

Warehouse lines, and other types of lender finance programs that are out there prevalent in our space?

Tom Hajda:

So I've seen warehouse lines as small as 5 million. Those are typically warehouse lines offered by a community bank to an existing bank customer that they know who wants to get into this business. And they start out small. And this is typically someone who has not yet set up a fund, but the sweet spot that I see is really between 25 and $30 million. There are some of the more prolific warehouse lenders. There's a bank on the west coast that really makes a lot of these warehouse lines and they have a $50 million minimum amount, but there are plenty of smaller regional banks that will make lines anywhere from 10 to 30. That's really the sweet spot that I've seen.

Kevin Kim:

And the next question here is, are the borrowers from any of these lenders more at risk, technically speaking, under any other particular type of lender? I think the question really is are these programs more risky compared to other types of loans? I think they're less risky from a bank standpoint. But what do you guys think?

Tom Hajda:

Risky from the lender's point of view or from the borrowers,

Kevin Kim:

I would imagine? I think that's a question. Are the borrowers from any of these lenders more at risk, technically speaking, under any other particular type program or lender? So I guess we're comparing and contrasting on risk on different types of lender finance programs. So my view on this has always been that if you're on the short term repo line, that's the riskiest one because you got to move that paper off the line fast. And if the secondary is dead, you're pretty much stuck with that loan, make that program worse if that program's marked to market. But your warehouse line facilities, I mean, I don't necessarily think that there are any more risk than any other program out there.

Tom Hajda:

I think that's right. If you're going to get one of these facilities, you need to make sure that you have an exit strategy, you have a dwell time. What's the strategy for getting these loans off the line? And once the line matures, do you have a fallback? Right? Right. What's your source of repaying the line or have you started to negotiate well before the maturity date to either extend the term or to refinance it with another warehouse line? Those are two very important considerations.

Kevin Kim:

And what type of leverage is most user friendly to the borrower from these lenders? So I think this is more ease of operation. And this is interesting because the hardest to qualify programs are the ones that I at least heard that are the easiest to work with. They have a very robust program when it comes to systems and processes. But at the same time, qualifying is very difficult, right? Because you have to have a certain net worth and the underwriting process is very thorough. And then there's the opposite where you can just go out there and borrow some money from some high net worth investor, I guess. So what do you guys think? I

Tom Hajda:

Think that's right. So my experience is that the repo facilities, the master repurchase agreements, they're much more complicated because they are structured to take advantage of the safe harbor and the bankruptcy rules. So there are more moving pieces to the transaction and there are additional restrictions and accounts and agreements that, so you're going to have a more robust set of transaction documents to begin with. You're going to have to set up additional operational policies to satisfy the repo buyer's requirements. But once it's set up, it tends to be fairly simple. So unlike a bank warehouse line, you typically have fewer fees with the master repurchase agreement. So you'll probably pay like 25 basis points for each advance, but you don't have minimum use fees and you won't have as many required accounts like banks will require you to keep all your principal operating accounts with the bank lender. So upfront it's probably a little more work and a little more expensive to set up a master repurchase agreement. But once you get it set up, there are fewer fees.

Kevin Kim:

Our next question is about if a warehouse lender takes possession of original loan documents and records, a collateral assignment of the deal of trust, is there filing a UCC financing statement to perfect the lender's security interest in the loan? Is the UCC still required? Basically, is the UCC filing still required? If they take possession,

Darren Roman:

Even though it may not actually be required because possession in a priority battle would prompt non possession in a filing, most warehouse lenders would actually do both. They all suspenders, they'll take possession and they file the UCC financ statements,

Kevin Kim:

Right? Because that's more of an Article nine, article eight question, right? In their UCC possession's, fine, but you also want to have something recorded. Okay. Alright, moving on. I'm going to skip the disaster stories. I don't think we have time for that.

A question from Tom, Ms. McPherson, some active banks and lenders that we've seen in the lender finance space? I think without, I don't want to play favorites. There's a lot of programs out there. Tom, if you want to give me a call, happy to give you some names. Tom here is also happy to give you some names. We want to be very diplomatic about this. There are a lot of programs out there, both bank, regional bank, national bank, financial institution, institutional investor, a lot of them. So a lot of great programs out there. Jerry's asking a question about describe strong leverage for one of us. I would imagine what this means is a lot of leverage, high leverage. So for the debt fund clients out there, my perspective on leverage on the fund is going to be anything exceeding a one-to-one ratio, it's a hundred million dollars fund, a hundred million dollars in leverage, that is considered the highest. That's considered acceptable when it comes to high net worth investors and family office and pension plan investors. There are funds that go as high as three to one leverage, three turns of leverage, a hundred million fund, $300 million in leverage. It exists, it's been done before, but it's kind of considered kind risky, right? But the vast majority of leverage out there, if they have one program, they're only able to borrow 65% whatever the advanced rate maximums are. Correct, Tom?

Tom Hajda:

Yeah.

Kevin Kim:

Yeah. So if it's a hundred million dollars fund and they're fully deployed with all the a hundred million dollars in loans, they'll be able to draw 65 million from the bank at any given time.

Tom Hajda:

Exactly. Right.

Kevin Kim:

Right. All right. And also liquidity. So this is actually a good question. Liquidity metrics. How do they measure liquidity when it comes to the underwriting process?

Tom Hajda:

Karen, you want to take that?

Darren Roman:

I think that generally does vary on the institutions, but it's a typical review of the financial statements in my experience when they're doing the underwriting to see what you have on hand. Not my experience. I've done a lot of liquidity reviews myself, so maybe Tom, you want to grab that one?

Tom Hajda:

Yeah, I mean the liquidity requirements really will depend in large part on the size, so the facility and the quality of the underlying collateral. But I've rarely seen anything less than 10 million for a line of any size.

Kevin Kim:

Right? I'll say the lowest I've seen it go is 5 million, but it's really pushing the limit there. Another question here is any alternatives to say RAI on the East Coast to do short-term facilities? Once again, do not want to play favorites here, but the short-term programs are generally offered by non-bank programs. I think there are a handful of banks that will offer it, but non-bank programs are probably going to be likely to offer this. I would speak to your favorite aggregator to find out more, right? A lot of them created programs like this over the years. They're your first ask and the person didn't leave their name. So if you want to find out more about that, feel free to ask us directly and we're happy to answer that question. How do you typically see warehouse lines used for construction loans? If you plan to keep the loan on your balance sheet? IE What percent of the loan will be from the warehouse on initial funding and future construction draws? Good question actually. How do these mechanics work when it coincides with the construction loan?

Tom Hajda:

Yeah, so I've typically seen the same advance rate for the initial draw to acquire the property as the advance rate on the future construction or rehab draws. So there are going to be any number of conditions for the warehouse lender to fund an advance for the rehab or the construction portion. And it tends to take a little longer because I've seen a lot of warehouse lenders using third party vendors to go and review the property to make sure that the construction meets the minimum requirements in the construction plan. But I haven't seen varying advance rates. I do know that upfront, many warehouse lenders, when they set the advance rate, it'll be maybe 65% of the as is value of the underlying mortgage property. And once you've fully funded all the advances, the borrowing base will be based on a lower percentage of the after improved. So that's really the only difference I've seen there. Have you seen anything different, Darren?

Darren Roman:

No, I think they make it pretty consistent across the board.

Kevin Kim:

Right. Do they insist if they know the borrower, so I guess our client lender is doing a lot of construction. Do they insist on certain things like third party fund control and those kinds of extra pieces?

Tom Hajda:

Boy, I tell you what, usually not interesting, but the larger lenders always do, but there's a very precise and strict regimen that the warehouse borrower has to follow. So when they submit their advance request, there's usually a schedule of documents that they need to provide in order to provide comfort to the warehouse bank that the work was done in accordance with the requirements and the documents.

Kevin Kim:

And this is why it's so important for our industry. We're doing fix and flip, which is rehab. We're doing construction loans, bridge loans. These loans are kind of capital intensive and also we're a fast moving industry. And so the primary motivation these warehouse lines are obtained for is for cash management. So cash drag in the lending business can be fatal to the business because you lose business, you don't want your borrowers, you don't want that key thing certainty to close, to become a question mark with you as a lender. So these facilities are designed to assist with that. And beyond that, there are the nice advantages that are gained ancillary when it comes to yield enhancement. But I think it's important for our audience to consider, if you're thinking about leverage, a yield enhancement tool, your investors will likely see through that, especially if you are a debt fund.

Next question here from Jerry. Sorry, meant a good leverage in bank view. Very short question there. I think what he's asking about what is the bank view as kind of a healthy amount of leverage, they're willing to offer this. Actually I would say this is more of an interesting comment. So I've seen a lot of funds out there getting multiple lines of credit. So for example, 500 million debt fund, they've got two or three different banks working with them. But is the aggregate amount a concern when they underwrite? So as an example, 500 million debt fund working with one bank going to Second Bank for another warehouse line. Is there some type of maximum leverage they're willing to consider when A-C-L-T-V kind of concept?

Tom Hajda:

Yeah, it really depends on the warehouse bank. So very often the warehouse line will limit the amount of additional debt that the warehouse borrower can incur after the warehouse line closes, right? So it could be an absolute prohibition from that specific borrower to having an additional line. And the most common structure that I see is the borrowing entity under the warehouse line tends to be a wholly owned, newly formed subsidiary of a fund or a subrate under the fund. And that borrowing entity is not allowed to have any other warehouse lines from any other warehouse lender. What many of my clients do is they'll set up a separate subsidiary to have a line from another warehouse bank, but there will be restrictions that are built into the warehouse line and it's totally dependent on what type of borrower you are. So I have a client in California, very large private lender, significant assets and income, and they probably have about seven or eight different lines under that are subsidiaries of different affiliated companies. For a smaller entity, you're going to see restrictions from setting up new subs or affiliates to have lines. And so the leverage limit will be constructed on a consolidated basis with the parent all the way down to the borrower entity.

Kevin Kim:

It is also important to consider the eligibility when it comes to the structure of the company. So a lot of times we've seen programs, platforms that are created where the primary investment strategy, it's a balance sheet lender, but the way they take on capital is via investor notes or investor notes secured by the mortgages or participation interests. And that kind of raises a flag for the bankers because they're not interested in there being any other lender secured by this particular mortgage, right? They don't want anyone beneath them, they don't want anyone. You don't want to be the only one. So that's also a point of consideration. So what was a very big trend before warehouse lines became very prevalent were these investor, no programs borrow payment independent, no programs, fractional programs. These are very difficult for banks to digest. Oh, okay. So Jerry clarified his question.

 

What do you mean large lender? I suppose loans outstanding. I don't think they care. I really don't. They want to see, when we say balance sheet of 5 million, 10 million, that really means loans on your books. So they want to see a book of about 10 million bucks, 20 million bucks in loans. So that's the eligibility requirement. They want to see that type of production. And to them, those are assets. Right? So John asked the question here, back in the day, I had a warehouse line with Indie Mac audit, financial required, but much lower net worth standards. Is this typical for captive lines in conventional conforming space or just due to this line created back in the late nineties? So I was a child in the nineties, so I'm not going to comment on this. So I do recall that being a lot less rules back in the nineties and the laws have, bank rules have changed a lot even since I left banking in oh six. So guys, any thoughts on how these have evolved over the years and how much more tight they become?

Tom Hajda:

I've seen the credit box tighten a lot, especially in the last 6 to 12 months, but the net worth requirement is directly proportional to the size of the line. And if you have a very large warehouse borrower that wants a modest line, they're not going to struggle at all with the net worth requirements. But I know that I've had a number of clients who did not satisfy the due diligence requirements in the last few months from perspective warehouse lender because they simply didn't have the net worth.

Kevin Kim:

And also one of the things to think about is there are different types of programs when it comes to lender finance and conventional and consumer non QM versus our sector. So vastly different types of arrangements, vastly different types of motivations and incentives on that side of the business. So John, sorry we weren't able to answer your question. This is really kind of geared around the business purpose residential type loans that are being offered out there in the market. So alright guys, I think that's all the time we have for today. I want to thank everyone for joining us on this webinar about leverage and Lender Finance. If you have any other questions, please feel free to ask either all three of us who are available to you guys by email or phone. You can go find our contact information on our website, Geracilawfirm.com. Once again, I also want to remind our audience to please visit us at Innovate coming up on April 17th to the 18th at the beautiful Balboa Bay Resort here in Newport Beach. So please come to that conference. It's going to be a great one. And for Geraci Law Firm as a whole, I want to thank you guys for listening and it's all the time we have. We are signing off.