Commercial Real Estate Finance Rei Ts


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Understanding commercial real estate finance and real estate investment trusts (REITs)

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Commercial Real Estate Finance Rei Ts

  2. 2. I. TRADITIONAL MORTGAGES The following is a summary of the types of lenders by category: The types of mortgages and related underwriting guidelines for residential and commercial property are quite different. In its simplest terms, a mortgage is a method of using real property as security for the repayment of debt. There are many variables to be considered to determine the best financing product for your investment. In general, there are three different types of loans on which banks lend: -Construction: A construction loan is a temporary loan usually lasting six months to a year that is used to complete a “to be built” project. Construction loans are paid off by a long-term mortgage loan on the completed project. The proceeds from a construction loan are disbursed in stages over the course of the project and the lender usually reviews the project at various stages of the construction. -Bridge: A bridge loan is a short-term loan that provides funds at the stage between the construction phase and completion of the project (i.e., permanent financing stage). Commercial bridge lenders may overlook property issues, incomplete permits, credit and other problems in exchange for a higher rate of return. It is likely that lenders will look to offset these risks by lending at a lower loan to value ratio, usually under 65% of the property's value. -Permanent: Permanent loans are generally loans with terms over three years. It is common for lenders to convert construction loans to permanent loans upon completion of construction. These loans are referred to as Construction-to-Permanent loans. Commercial Mortgages and Real Estate Loans Types of Commercial Property The following is a breakdown of the various commercial property sectors. Each sector faces its own set of issues that impact your ability to secure financing. Multi-Family • Garden Apartments • Hi-Rise Apartments • Mid-Rise Apartments • Low/Mod Income
  3. 3. • Student Apartments • Senior Apartments • Underlying Coop Retail • Regional Enclosed • Strip Center • Outlet Mall • Free Standing • Single Tenant • Regional Unenclosed Office • Single Tenant • Hi-Rise Tower • Mid-Rise Office • Office Over Retail Heavy • Manufacturing • Light Manufacturing • Warehouse/Distribution • Owner Occupied • Multi-Tenant • Self Storage • Special Purpose Health Care • Congregate Living • Nursing Home • Rehabilitation • Ambulatory Care Source: The Lender’s Perspective: Commercial Underwriting Guidelines Underwriting standards and pricing of a loan is determined by the type of real estate, tenancy, credit of the borrower and the institution or individual lending the funds. In particular, the pricing is generally directly related to the risk associated with a particular loan. Institutional lenders lend based on their cost of funds and access to capital. When applying for a commercial loan, lenders typically evaluate certain criteria
  4. 4. to determine whether a particular loan will meet its underwriting guidelines. The following is a brief summary of some of the most common underwriting guidelines: Financial Analysis The debt coverage ratio (“DCR”) is a crucial element to a lender’s evaluation of a loan. The DCR is defined as the monthly debt compared to the net monthly income of the property. Each lender has its own DCR policy and it’s important to understand what the policy is before submitting an application. Most lenders will never go below a 1:1 ratio (a dollar of debt payment per dollar of income generated) because anything less then a 1:1 ratio will result in a negative cash flow situation. Loan to Value Lenders typically view commercial investment properties more conservatively. Lenders also look at the loan to value (“LTV”) ratio in evaluating an application. The LTV is the percentage calculation of the loan amount divided by purchase price. It is common for commercial lenders to require a larger upfront commitment from buyers (i.e., a minimum cash payment of 20% by buyers). In commercial transactions, it is imperative that the appraisal reflect the highest valuation for the property. This will enable the buyer to receive more loan proceeds based on the LTV calculation. Credit Worthiness In general, commercial loans are held in the name of the business owning and/or investing in the commercial property. If the business is less than three years old, it is likely that the lender will require a personal guaranty from the principals of the company. Further, lenders will rely on the credit history of the principals in evaluating a prospective loan. Property Analysis In many instances, a commercial lender will conduct a fairly thorough analysis of the fair market value of the subject property. Lenders will also analyze other characteristics that may impact the value of a property (i.e., age, appearance, local market, location, and accessibility). Funding Needs Capital Source
  5. 5. -Acquisition and Development: Raw land infrastructure development (streets, utilities, etc.) -Adjustable Commercial Mortgage: Interest moves with a specific index (Prime, T- Bills, etc.) -Construction Mini-Perm: Construction with 3 to 5 year loan, usually on income property. -Construction Loan with Take-out: Construction with pre-arranged takeout loan in place. -Fixed Rate Commercial Mortgage: Interest Rate remains constant throughout the term. -Hard Money Loan: Loans from private lenders based primarily on the hard asset value (commercial building, vacant land, etc.). -Interim Loan: A short term (2 yrs or less), bridge or project type loan. -Joint Venture: A financial partner in the development of real estate. -Participating Mortgage: Lender receives a kicker for gross income above a preset level. -Real Estate Sale and Leaseback: Lender purchases land and leases back to borrower (generally developer) for a fixed rent plus other considerations. Mortgages are issued on leasehold at market rates. Usually, produces more dollars than a mortgage.
  6. 6. -Real Estate Purchase Loan: Lending for the purchase of commercial real estate. -Second Mortgage(Commercial): Loan secured by equity behind that of the first lien. -Wraparound: Lender makes a second mortgage and assumes the first mortgage. The Borrower’s Perspective: Closing Commercial Loans Commercial loans present a variety of legal and business issues that both borrowers and their attorneys needs to recognize and negotiate. It is important for attorneys to determine the legal issues that are important to their clients and the timeframe within which the loan needs to close. Borrowers are mostly concerned with their liability under the documents and the restrictions contained therein that relate to borrower’s ability to operate their business. The following discussion addresses some of the more common issues presented by commercial loans. Prepayment Provisions It is common for commercial loans (especially fixed rate loans) to include a prepayment provision that limits a borrower’s ability to prepay all or part of the loan prior to a date certain. . A prepayment penalty is a fee that is paid to the lender to compensate it for the lost income it would have earned if the loan was not repaid prior to the maturity date. It is imperative to address the prepayment terms so that the borrower will have the flexibility to prepay the loan. Borrowers may with to prepay the loan if they are able to refinance at lower interest rates or sell the property. The prepayment provision should not be applicable in the event of certain involuntary prepayments (i.e., prepayment due to application of casualty process or condemnation). Recourse A recourse loan is a loan where the lender can look to both the collateral securing the loan (i.e., the property) and the borrower in the event of default. A non-recourse loan
  7. 7. means that a lender can only look to the collateral to satisfy the loan obligations in the event of default. It is common for a non-recourse loan to have a “bad-boy” provision that allows the lender to look to the borrower if the borrower engages in certain bad acts. These “bad-boy” provisions are essential carve-outs from the non-recourse aspects of a loan that allow the lender to go after the borrower in the event of intentional acts by its borrower. These certain circumstances include: environmental contamination, misappropriation of funds, fraudulent misrepresentation, waste, and other types of serious defaults. The loan documents should clearly limit liability to the appropriate parties. For example, if the borrower is a partnership, the lender’s recourse should be limited to the assets of the partnership and exclude recourse against the members of the partnership. Further, the recourse provisions should be limited to actual damages incurred by a lender rather than converting the loan to full recourse in the event of a violation. In addition to the “bad-boy” provision, a bankruptcy or similar attempt to limit lender’s ability to enforce/foreclose the lien against the property may also give the lender recourse against the borrower. Remedy and Default Provisions The remedy provisions of the loan documents should be reviewed carefully to ensure that the lender is not entitled to any extraordinary or inappropriate remedies. It is difficult to negotiate remedies since these provisions are only effective in the event of a borrower default. However, you can negotiate for appropriate grace periods and/or cure periods to limit the events of default. Further, the events triggering a default should also be negotiated to exclude circumstances outside the borrower’s control. For example, loss of rental income due to tenant’s financial difficulties could cause a default on the debt service coverage ratio. It may be possible to negotiate for a provision that would allow the borrower to reduce the principal of the loan to remedy any debt service coverage ratio defaults due to such loss of income. Environmental Matters Liability for environmental matters can be a major concern with commercial properties, especially with respect to certain types of property. It is common for loan documents to contain expansive representations, warranties and covenants from the borrower regarding environmental matters. These provisions need to be carefully
  8. 8. reviewed and negotiated to limit borrower’s exposure. For example, the provisions should exclude matters contained in existing environmental reports and include only matters within the borrower’s actual knowledge. It is critical for the borrower and its advisors to conduct a thorough due diligence investigation of a property to uncover any potentially harmful conditions. The borrower’s representations should provide a basis for liability only for matters that the borrower willfully withholds or omits. Environmental indemnification provisions also need to be negotiated and limited in time and scope. First, the loan documents should provide that the borrower’s liability for environmental matters ceases upon a sale or transfer of the property. The lender may seek to extend such liability after the borrower sells or refinances the property. It is common for loan documents to provide an indemnification period through the statute of limitations for the relevant environmental matter. Borrower’s should seek to have the indemnification period limited to a date certain after closing because the statute of limitations for certain environmental matters does not begin to toll until discovery of an environmental condition. Assignment of Leases Lenders often seek to exercise control over the borrower’s lease arrangement with its tenants because it is a major source of income that is used to repay the debt. Borrower’s, however, need to maintain a certain level of control over its leasing arrangements in order to effectively operate its business and maximize income. As such, the borrower should attempt to limit the lenders control over its rental income and leasing arrangements. It may be possible to create a “Form of Lease Agreement” that is reviewed and approved by the lender at the loan closing that can be used for future tenants. In the event that the lender does maintain some control over leasing decisions, the loan documents should provide very clear terms and conditions and time limits for the lender’s involvement. Transfers The loan documents will provide for restrictions on transfers of the property and/or transfers of interests in the borrowing entity. The borrower should seek the flexibility to transfer the property under certain limited circumstances. Further, the ability to add or remove members or partners from the borrowing entity should also be
  9. 9. retained given that the borrower’s circumstances post-closing may change. It is likely that the lender will require the managing member or general partner to remain obligated under the loan documents. Transfer restrictions may be drafted so broadly as to include put/call rights or rights of first offer that may be included in the operating agreements of the borrower. If your investment is structured to include those sorts of rights, the transfer provisions should be modified to specifically exclude those circumstances. Borrower Entities Lenders will often require that a borrower be formed as a single asset entity, special purpose entity and securitized loans. This requirement is generally imposed to limit the lender’s exposure to bankruptcy and default by isolating the collateral owned by the borrower. If the entity is formed properly, affiliate entities of the borrower that experience financial difficulties will not affect the subject property. The main implication of these provisions for the borrower is the additional transaction cost of forming and maintaining the new entity (for a purchase) or transferring the property (for a refinance). Lenders involved in securitized loans will require that the borrowing entity be a “bankruptcy remote.” The loan documents will include several covenants that relate to the maintenance of such an entity. Some of the common requirements are as follows: • Maintain the borrower’s assets in a way which segregates and identifies such assets separate and apart from the assets of any other person or entity; • Hold itself out to the public as a separate legal entity distinct from any other person or entity; • Conduct business solely in its own name; • Have no indebtedness other than a loan being made secured by a particular property and indebtedness for trade payables incurred in the ordinary course of business; and • Have “independent directors” that must vote on matters involving the dissolution or bankruptcy of the borrower and certain amendments to the borrower’s organizational documents. II. SECURITIZATION OF DEBT
  10. 10. What is Securitization of Debt? Securitization of debt is a process by which identified pools of receivables, which are usually illiquid on their own, are transformed into marketable securities through suitable repackaging of cash flows that such receivables generate. Essentially, securitization is a credit arbitrage transaction that permits for more efficient management of risks by isolating a specific pool of assets from the originator's balance sheet. Securitization is a method of obtaining investment capital by selling interests in a pool of financial assets (such as mortgage loans) to investors in the capital markets. The lenders are able to diversity their investment and spread their risk of loss by pooling their funds and investments together. A traditional lender lends money to borrowers from its own balance sheet. With securitization, the lender raises money in the capital markets to lend to borrowers. After a loan is originated, the loan is pooled together with other loans, transfers it to an arranger who then sells the income from such pool to investors in the form of securities in the capital markets. Parties to a Securitization The following is an overview of the parties involved in a typical securitization: -Originator—Owner and “generator” of the assets to be securitized (i.e., banks and other financial institutions, governments and municipalities). -Seller—Seller of the assets to be securitized. -Purchaser/Issuer—A special purpose entity (SPE) that purchases the assets to be securitized and funds the purchase price by issuing asset-backed securities into the capital markets. -Servicer—services the assets to be securitized and is responsible for collection, administration and, if necessary, enforcement of the receivables; -Investors—Purchasers of the asset-backed securities in the capital markets (i.e., pension funds, banks, mutual funds, hedge funds, insurance companies, etc.). -Lead Manager—Arranger of the transaction who is often the primary distributor of the asset-backed securities in a particular transaction.
  11. 11. -Rating Agencies—Rate the asset-backed securities that are issued. The three key rating agencies for securitizations are Standard & Poor’s, Moody’s and Fitch. -Hedge Providers—Hedge any currency or interest rate exposures the Purchaser/Issuer may have as a result of the securitization. -Cash Administrator—Provides banking and cash administration services to the Issuer. -Security Trustee—Acts as a trustee for the secured creditors of the Purchaser/Issuer. -Note Trustee—Acts on behalf of the holders of the asset-backed securities. -Auditors—if necessary they audit the asset pool as may be required under the documentation of the relevant transaction. Benefits of Securitization The Lender/Originator’s Perspective There are several reasons why lenders engage in securitized lending and the sale of asset-backed securities: -Access to Funds—Originators are able to raise funding in the form of the purchase price to be paid by the SPE upon the sale and transfer of the securitized assets. -Credit Exposure—Following securitization, the Originator’s credit exposure will be limited to any credit enhancement it may provide. -Improved Balance Sheet—A true sale securitization improves the Originator’s balance sheet ratios to the extent that proceeds of the securitization are used to repay existing liabilities, which may reduce the Originator’s leverage. -Access to Funding Sources—Securitization allows the Originator to diversify its funding sources away from banks in favor of the capital markets, without having to issue securities on its own. Originators who already have established direct access to the capital markets. -Reduced funding costs. The weighted average cost of the securitization may be lower than the cost of the Originator’s current bank or other debt. Notably, this is often the case if the credit quality of the securitized assets is higher than the credit quality of the Originator’s balance sheet as a whole. The Investor’s Perspective Investors in asset-backed securities can benefit in a number of ways, including the following:
  12. 12. -Portfolio Optimization—Asset-backed securities provide a means for investors to invest in asset classes and risk tranches of their choice and generate the associated returns. -Reduced Volatility. Asset-backed securities have historically often been less volatile as compared to corporate bonds. -Favorable Yield Premium—Asset-backed securities have been known to offer a yield premium over comparably rated government, bank and corporate bonds. -Risk Diversification—Asset-backed securities are usually not susceptible to event risk or the risk of a rating downgrade of a single borrower. Issues with Securitized Loans The purpose of a securitization transaction is to separate the borrower’s credit risk from the leveraged asset. As a result, securitizing lenders deal with credit risk differently than traditional lenders by structuring the loan and the borrowing entity in a way that segregates the leveraged asset and requires higher impounds and reserves at closing. The main issues with securitized loans are summarized below. Credit Risk In order to reduce credit risk, securitized lenders require that borrowers place the collateral property in a special purpose vehicle (or SPV) thereby removing it from the borrower’s balance sheet. The SPV is the borrower under the loan documents and is the subject of several restrictive operational covenants. These requirements are intended to isolate the property from other creditors and give the lender additional control of the property after a default. In general, the rating agencies will ignore the credit risks related to the borrower and look only the asset and immediate liabilities related to the property itself. As a result, securitized loan documents focus more closely on property cash flow and require stricter covenants on late rents and tenant vacancies and debt-service coverage ratios. A traditional lender is generally more focused on borrower’s financial status and loan-to-appraised value ratios. Another method to reduce credit risk involves the use of impounds and reserves. Rather than relying solely on borrower covenants, the securitized lender will require pre- payments at closing of post-closing liabilities that could impact the collateral. SPV
  13. 13. borrowers will be required to fund reserve accounts for taxes, insurance and maintenance. Lenders may also require additional insurance that would cover business interruption. Credit Enhancement A traditional lender may require credit enhancements if it determines that a proposed loan has a high credit risk. Credit enhancements can take the form of additional collateral, guarantees from creditworthy third parties, or cash reserves. On the other hand, securitized lenders generally seek credit enhancements from the assets of the SPV itself and cash reserves at closing. Third party credit enhancements are generally avoided because this arrangement would require additional disclosure by the arranger in the investor documents because the loan would not be in accordance with its uniform standards. Additionally, rating agencies may lower their ratings which decrease the price that investors are willing to pay for the asset-backed securities. However, several originators and arrangers allow certain risks to be covered by a third party guaranty, such as “bad boy” acts and environmental risks. Restrictions on Junior Debt Securitized lenders generally prohibit borrowers from incurring any junior debt. In generally, the loan documents only permit the SPV borrower to incur the senior securitized debt, liabilities to existing tenants under leases and trade debt incurred in the ordinary course of business. These restrictions must be carefully considered while negotiating the loan package. Bankruptcy Remote Structures Securitized lenders require that borrowers form an SPV to reduce the likelihood that the borrower will become subject to a bankruptcy proceeding. In addition, lenders generally require that a borrower adopt special charter and covenant provisions intended to impair the borrower’s ability to file bankruptcy. This is called a “bankruptcy remote” structure. BRVs also make certain covenants that are designed to maintain its corporate identity separate from its parent, which reduces the risk that the BRV will be pulled into the parent’s balance sheet in the parent’s bankruptcy proceeding. Lenders will also require additional legal protection that is designed to assure the original contribution of the property to the BRV was valid and not a fraudulent transfer. Insurance Proceeds
  14. 14. All lenders require that borrowers maintain insurance coverage against the risks of loss, usually with the lender listed as an additional insured in the loss payee clause of such policy. The objectives of a securitized lender is different than that of a traditional lender because they are interested in uninterrupted cash flow so that they can make payments on the securities over a period of time. As a result, securitized lenders may include a requirement that the insurance proceeds from a casualty be used to rebuild the property rather than applying such proceeds to repay such loan. Prepayment Provisions Traditional lenders may permit prepayment of a loan without penalty, but this is usually figured into the loan pricing. Some lenders will restrict a borrower’s ability to prepay by limiting the time period, amount of prepayment and application of certain prepayment fees. On the contrary, prepayments of securitized loans are always penalized by a fee which may be characterized as a “yield maintenance fee,” “breakage fee” or similar defeasance provision. The terms of the loan documents will penalize or mitigate prepayments to assure predictability of repayment. The objective of these fees is to compensate the lender for the “time-value-of money” as if the loan would have remained outstanding until the scheduled maturity date. A defeasance provision is where the original collateral is replaced by reliable financial instruments (such as Treasury securities) that compensate the lender in the same way as the remaining debt service. Defeasance is a method to maintain the original payment stream despite the fact that the original asset has been removed. Transfer Rights Transfers of securitized loans are the norm. The objective of securitization is for a lender to transfer a loan off of its balance sheet and into a securitized loan pool owned by investors. In traditional loans, borrowers may seek to restrict the lenders right to transfer a loan to maintain continuity of the business relationship with the lender. This is not a realistic option with securitized lenders. Mortgage-backed securities are relatively easy for an investor to evaluate as a result of the use of rating agencies, standardized loan packages and summary disclosure documents. Standardized Loan Packages
  15. 15. In packaging loans for securitization, arrangers require originators to use standardized loan packages that have been developed for model disclosure and risk analysis. The use of the standardized loan packages is critical to the reduction of administrative costs that would otherwise be involved in evaluating unique loan packages. Pre-Pooling Analysis Before loans are placed in a securitization pool, the loan packages are reviewed for completeness and conformity to the pooling requirements. If there are deviations from the pool requirements, a loan may be rejected by the arranger. A non-standardized loan will not be acceptable because it renders the arranger’s uniform disclosure to investors untrue with respect to that loan. III. REAL ESTATE INVESTMENT TRUSTS A real estate investment trust (or REIT) is a business entity that invests in real estate directly, either through properties or mortgages. REITs are financial vehicles that allow investors to pool funds for participation in real estate ownership or financing. Since 2001, REITs have been included in the Standard & Poor’s 500 Stock Index, the most widely followed investment performance benchmark for U.S. equity markets. This addition is evidence of the importance of commercial real estate in public capital markets. REITs over time have demonstrated a historical track record providing a high level of current income combined with long-term share price appreciation, inflation protection, and prudent diversification for investors across the age and investment style spectrums.1 To qualify as a REIT, a company must distribute at least 90% of its taxable income to its shareholders annually. A company that qualifies as a REIT is permitted to deduct dividends paid to its shareholders from its corporate taxable income. As a result, most REITs remit at least 100% of their taxable income to their shareholders and therefore owe no corporate tax. Taxes are paid by shareholders on the dividends received and any capital gains. Most states honor this federal treatment and also do not require REITs to pay state income tax. Like other businesses, but unlike partnerships, a REIT cannot pass any tax losses through to its investors. REITs receive special tax considerations, and 1 Investors Guide to Real Estate Investment Trusts, National Association of Real Estate Investment Trust.
  16. 16. typically offer investors high yields as well as a highly liquid method of investing in real estate. There are three basis types of REITs: • Equity REITs: Equity REITS invest in and own properties (thus responsible for the equity or value of their real estate assets). Their revenues come principally from their properties' rents. • Mortgage REITs: Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate, or invest in (purchase) existing mortgages or mortgage backed securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans. • Hybrid REITs: Hybrid REITs combine the investment strategies of Equity REITs and Mortgage REITs by investing in both properties and mortgages. Dividends and Diversification As discussed further below, REITs must pay out almost all of their taxable income to shareholders. REITs can provide investors reliable and significant dividends (four times higher than those of other stocks, on average). Analysis of historical data concluded that the relatively low correlation between REITs and other stocks and bonds makes them a powerful diversification tool. Forming & Qualifying as a REIT The following generally summarizes some of the basic tax law requirements applicable to REITs. These rules are complex, and the following is only a general summary. In order to qualify as a REIT, an entity must meet a number of organizational, operational, distribution, and compliance requirements. Organizational Requirements A REIT must be formed in as an entity taxable for federal purposes as a corporation. It must be governed by a board of directors or trustees, and its shares must be transferable. Beginning with its second taxable year, a REIT must meet two ownership tests: it must have at least 100 different shareholders (or the 100 Shareholder Test), and 5 or fewer individuals cannot own more than 50% of the value of the REIT's stock during the last half of its taxable year (or the 5/50 Test). These ownership requirements generally mean
  17. 17. that the REIT structure is not a good choice for a closely held family business. A number of "look through" rules currently apply when determining whether the REIT meets the 5/50 Test. In an attempt to ensure compliance with these tests, most REITs include percentage ownership limitations in their organizational documents. For example, many REITs do not permit any one shareholder to own more than at most 9.8% of a REIT's stock without a waiver by the REIT's board of directors. Because of the need to have 100 shareholders and the complexity of both of these tests, general legal, and tax and securities law advice are strongly recommended prior to beginning the process of forming a REIT. Operational Requirements The REIT must satisfy two annual income tests and a number of quarterly asset tests that are designed to ensure that the majority of the REIT's income and assets are derived from real estate sources. • Annually, at least 75% of the REIT's gross income must be from real estate-related income such as rents from real property and interest on obligations secured by mortgages on real property. Additionally, 95% of the REIT's gross income must be from the above-listed sources, but can also include other passive forms of income such as dividends and interest from non-real estate sources (like bank deposit interest). As a result of these rules, no more than 5% of a REIT's income can be from nonqualifying sources, such as from service fees or a non-real estate business. A REIT can own up to 100% of the stock of a "taxable REIT subsidiary" ("TRS"), a corporation with which a REIT makes a joint election that can earn such income. • Quarterly, at least 75% of a REIT's assets must consist of real estate assets such as real property or loans secured by real property. Although a REIT can own up to 100% of a TRS, a REIT cannot own, directly or indirectly, more than 10% of the voting securities of any corporation other than another REIT, TRS or qualified REIT subsidiary ("QRS"), a wholly- owned subsidiary of the REIT whose assets and income are considered
  18. 18. owned by the REIT for tax purposes. Nor can a REIT own stock in a corporation (other than a REIT, TRS or QRS) the value of whose stock comprises more than 5% of a REIT's assets. Finally, the value of the stock of all of a REIT's TRSs cannot comprise more than 20% of the value of the REIT's assets. Distribution Requirements In order to qualify as a REIT, generally, the REIT must distribute at least 90% of the sum of its taxable income. To the extent that the REIT retains income, it must pay tax on such income just like any other corporation. Compliance Requirements In order to qualify as a REIT, a company must make a REIT election. The REIT election is made by filing an income tax return on Form 1120-REIT. Because this form is not due until, at the earliest, March 15th following the end of the REIT's last tax year, the REIT does not make its election until after the end of its first year (or part-year) as a REIT. Nevertheless, if it desires to qualify as a REIT for that year, it must meet the various REIT tests during that year (with the exception of the 100 Shareholder Test and the 5/50 Test, both of which must be met beginning with the REIT's second taxable year.) Additionally, the REIT annually must mail letters to its shareholders of record requesting details of beneficial ownership of shares. Significant monetary penalties will apply to a REIT that fails to mail these letters on a timely basis. Advantages of REITs Investing in real estate assets through the purchase of REIT shares provides certain advantages not offer by alternative investments, including: -Double taxation of distributions is avoided, thereby allowing more of the investor's capital to compound. -An experienced management team is responsible for the day-to-day operation of the business, providing the investor with real estate industry expertise. -Unlike real estate directly held by the investor, REITs are a liquid asset that can be sold fairly quickly to raise cash or take advantage of other investment opportunities.
  19. 19. -Investors with are able to diversify their holdings between various geographic areas and property specializations, which would not be financial feasible for most investors through direct ownership of property. -REITs have access to debt and equity markets to raise funds to take advantage of opportunities when they arise. -REITs have a lower correlation to equities than many other asset classes, providing portfolio stability for those with an active asset allocation strategy. -High cash dividends relative to the market tend to establish phantom bottoms to REIT share prices, often keeping them from falling as far as common stock in bear markets. IV. CONSTRUCTION FINANCING Construction financing is used to cover the variety of costs and expenses that are incurred during the course of a construction project, including without limitation the following: Soft costs: Architectural, engineering, survey, construction permits, local taxes, utility connection fees, and in general all the fees associated with the things that are done on paper before the actual construction starts. Hard costs: Actual cost of construction incurred from the moment the digging begins all the way to laying the floor coverings and putting the landscaping and hardscaping in. Closing costs: All costs associated with closing the construction loan, including origination fees, lender fees, title insurance, escrow or attorney fees, property insurance, course of construction insurance, recording, funding and closing fees. Land/Lot Value: The value of the land/lot to be built on or the structure that is being improved. To determine the current land/lot value: (i) if the property is owned for more than a year the fair market value is used or (ii) the purchase price is used if owned for less than a year. If there is an existing property that will need to be
  20. 20. demolished, then the land/lot value may be the current fair market value of the total property or the empty lot depending on the particular program’s guidelines. Interest reserve: The interest reserve is determined by calculating 60 or 70% of the simple interest on the total construction loan amount. This reserve will be used to make the payments on the construction loan during construction. Interest is calculated based on the actual amount borrowed at any one time and charged against the interest reserve during construction. Contingency reserve: A contingence reserve is always built into the budget to ensure the timely completion of the project despite unforeseen price increases or cost over runs. Contingency reserve is normally calculated at 5% of the total cost of construction. Inspection fees: Construction loans are reimbursement loans and as such, funds are disbursed based on the work completed as verified by an inspector. There are several ways to obtain financing for construction. Some of the more common methods used by commercial developers are: -Equity Financing—An investor provides funds for the construction in return for equity in the business entity that is operating as the developer. -Joint Ventures—An existing developer may enter into an agreement with a third party individual or company to provide funds in exchange for a participation fee in the profits realized from the construction project. -Traditional Financing—A lender provides a loan for the construction (which is the most common method and is discussed in detail below). Types of Construction Loans Constructions loans are generally structured to be temporary in nature and replaced by permanent financing upon completion of the building project. There are two basic types of construction loans: -Construction-to-permanent loan: Generally, the borrower will only pay the loan interest during the construction phase. After completion of the project, the loan converts to a traditional mortgage where the borrower begins paying principal and interest. One of
  21. 21. the main advantages of this type of loan is that there is one loan application and one closing. As such, borrowers are able to reduce the underwriting and closings costs associated with two separate loans (i.e., mortgage taxes, title insurance fees, and other closing costs). One disadvantage is that borrowers are not free to shop around for better permanent financing at the completion of the project. -Construction-only loan: This structure requires a separate loan for construction purposes and a mortgage upon completion of the project. Only the interest is paid during the term of the construction loan (usually short term) with the principal becoming due when construction is complete. There are generally more closing costs with these types of loans because there are two closings. However, borrowers are free to shop around for permanent financing during the construction phase which may be advantageous depending on market conditions. Steps to Obtain a Construction Loan Collateral: Many lenders will require the borrower to own the land before they can apply for a construction loan. The lender will use the underlying land as its collateral for the loan. Some lenders, however, will allow borrower to roll-up the land acquisition with the construction financing. Timing: Construction loans are generally short term loans with interest only payments during the term and the principal becoming due at the end of the term. Budgeting: It is critical to create an accurate budget for the entire project before applying for the loan. As such, the borrower must obtain and evaluate any third party quotes before creating the project budget. Lenders are averse to increasing amounts borrowed after the construction has commenced. Draws: Disbursements of the loan proceeds are called “draws.” The borrower will seek to correspond the timing of the draws with payments of anticipated expenses in the budget. V. CONVERTIBLE DEBT
  22. 22. In addition to debt financing (i.e., mortgages) and equity financings (i.e., private placements of securities), convertible debt is another financing alternative available to real estate owners and investors. Convertible Debt is a loan (debt obligation) that can convert to equity (stock ownership) under certain circumstances usually at some pre- announced ratio. Convertible debt can take the form of corporate bonds, convertible preferred stock, or mandatory convertible securities. Investors tend to like convertible debt because they are in a “win-win situation”: if the borrower does well the investors shares in the upside of the equity and if the borrower does poorly the investor is still entitled to repayment of the debt obligation. Although it typically has a low interest rate, the holder is compensated with the ability to convert the debt to common stock, usually at a substantial premium to the stock's market value. From the issuer's perspective, the key benefit of raising funds by issuing convertible debt is a reduced cash interest payment. The primary disadvantage, however, is that the value of shareholder's equity is reduced due to the dilution expected when holders convert their debt into equity. Raising Funds Using Convertible Debt Convertible debt offerings are essentially securities offerings that can be made publicly for listed companies or through private placements. It is critical to consult with a securities law attorney before offering or issuing any convertible debt to ensure that you are in compliance with all applicable federal and state securities laws. Issuers will need fairly detailed disclosure documents (i.e., private placement memorandums, subscription agreements, notes evidencing the debt and call provisions, etc.).