Chapter 19

Permanent Financing of Commercial Real Estate

Properties

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Chapter 19 Learning Objectives Understand how concepts such as agency problems, interest rate

risk, and leverage apply to permanent commercial property financing

Understand the differences between permanent commercial property finance and residential or acquisition , development, and construction finance

Understand how equity participation loans are structured Understand the lease-versus-own decision Understand the mechanics of a sale-leaseback

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Financing Commercial Real Estate

Use of long-term, fixed-rate loans Originated by financial institutions, life insurance companies, pension funds

More complex underwriting and lower LTV ratios than residential loans

Unlike residential mortgages most commercial loans have prepayment penalties Use of yield maintenance prepayment penalty

Nature of collateral – The note is likely to have an assignment of rents clause (lender can collect rents in case of default)

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Equity Participation Loans

Lender offers a lower interest rate for a share of the income and/or price appreciation of the property

Increased risk for the lender in giving up interest

Decreased risk for the borrower through lower interest

Discount rates should reflect risk levels

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Lease Vs. Own Decision

Owning: Interest is tax-deductible, can depreciate, receive price appreciation

Leasing: no down payment, avoids expense of incurring debt, tax deduct the lease payments, no price appreciation

IRS may consider the lease to be a financing arrangement

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Leasing Vs. Owning Leasing advantageous if:

The firm expects to use only a portion of the asset or expects to use the asset for a short period of time

The current owner cannot take advantage of depreciation through sale-and-leaseback and can obtain more advantageous lease terms if the new property owner can use the depreciation write-off

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Leasing Vs. Owning (Cont.) Leasing advantageous if:

Property is fully or nearly fully depreciated – a sale is the only way to obtain a stepped-up basis to its current market value

Window dressing of firm’s financial statementsSelling the assets and leasing them back (for lease payments similar to

the interest payments on debt) results in lower total assets and hence higher ROA.

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Sale-Lease Back Agreements

Sell the property and simultaneously lease it back from the new owner

Seller may agree to repurchase at end of lease period at a guaranteed price or indemnify the buyer if property prices fall and option to buy is not exercised

Satisfies immediate need for cash while retaining use of the facility

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Leases and Accounting Regulations

Operating lease is a normal business lease

Capital lease is a substitute for debt financing.

Criteria for capital lease: Transfer of ownership

Option to repurchase

Lease term is >= 75% of asset life

PV of lease payments >= 90% of asset value

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Accounting for Real Estate Sale-Leasebacks

SFAS 13 – accounting for leases SFAS 28 – accounting for sales with leasebacks SFAS 66 – accounting for sale of real estate SFAS 98 – accounting for leases: sale-leaseback

transactions involving real estate, sales-type loans of real estate, definition of lease term, initial direct costs of direct financing leases.

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Ground Lease Mortgages

Land is not owned but leased from owner for development

Most common in dense populations

Ownership of improvement passes to land owner at expiration of lease

Leases are long-term (maybe 50 years)

Sometimes treated as real property

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Credit-Based Financing

Uses the tenant’s good credit rather than the real estate as basis for financing

Useful when the tenant’s credit stronger than landlord

Two formats available: Multisite securitization - a pool of facilities is net leased to the tenant

Tenant improvement financing with a personal property lease

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