Commercial Real Estate Fundamentals: Prepaying A Loan With Defeasance Or Yield Maintenance
Your commercial real estate loan may have restrictions on prepayment. A loan may be locked out entirely to prepayment for the first few years of the loan term and then be open with a penalty based on yield maintenance or defeasance. Prepayment restrictions will hinder business flexibility if you need to quickly refinance or sell the asset. Be aware of the nuances regarding prepayment as you negotiate your loan agreement. You will have to live with those terms later.
Prepayment restrictions are designed to preserve the lender’s yield on your loan. Securitized lenders or investors want a predictable cash flow stream without disruption from prepaid loans. A securitized loan often has a prepayment lock out period of the earlier of 2-3 years from origination or the securitization date. Try to negotiate an open prepayment period without a penalty at the end of the loan term. Three to six-month open prepayment windows are common in commercial loan agreements. Also, be sure your prepayment penalty calculation excludes any open prepayment period in the loan agreement. You shouldn’t pay a penalty on the period where you wouldn’t otherwise be charged a premium.
Yield maintenance is a predefined formula in the fixed rate loan agreement which uses the current bond market yields to discount the remaining loan payments in the term. If current market interest rates are lower than your loan interest rate then the yield maintenance premium will be positive. If market rates are higher than your loan interest rate then the formula returns a zero premium. However, the lender usually writes a second test with a fixed percentage of the outstanding loan balance so it ends up with a premium in its pocket anyway. Some lenders use a sliding percentage of the principal to calculate the premium. Floating rate loans can have spread maintenance premiums and both types of loans can have prepayment lock out periods where any prepayment is prohibited.
If your loan was securitized it was likely pooled into a REMIC trust (Real Estate Mortgage Investment Conduit). The trust issues securities (CMBS) to investors who want predictable cash flow. Defeasance is the prepayment solution that substitutes collateral for the encumbered property so the investor cash flow continues uninterrupted. Your defeasance consultant will be knowledgeable about purchasing the optimal replacement securities, the possible use of higher yielding agency issues, properly forming the successor borrower, how to handle any positive residual value from the securities and how to split the gain with the servicer. The borrower should carefully negotiate generous defeasance terms when they make the original loan because the servicer relies on them at the time of prepayment.
You’ll work with the trust servicer for any defeasance prepayment. The master servicer is limited by the terms in the loan agreement and the master servicing agreement. REMIC rules are very rigid and designed to preserve favorable tax treatment for the trust. Any violation of the REMIC rules could result in a large tax penalty for the trust and its investors. A defeasance transaction usually takes about 30 days to complete but can be done quicker depending on the circumstances and the ability of the defeasance consultant. A defeasance transaction may be reviewed by one or more rating agencies to ensure compliance with the loan agreement and REMIC rules. The process of rating agency review is time consuming and expensive with legal costs for the borrower, trust and rating agency usually paid by the borrower.
New York, Washington D.C., Maryland, Minnesota, Florida and Virginia have allowed a variation on defeasance called a new-note defeasance or New York style defeasance. The borrower can avoid some or all of the costly mortgage recording tax by using a complicated process of assignments and pledges between the REMIC trust, the borrower and the new lender. Seek assistance from a qualified attorney and defeasance consultant before deciding on a form of defeasance.
The decision to prepay a loan through defeasance or yield maintenance should be based on economic, legal and strategic considerations. A wise borrower looks ahead in a credit constrained environment and evaluates the probability that replacement financing will be available at maturity. Favorable credit market rates and terms may drive the decision to prepay with penalty to improve distributable cash flow. The pool of available buyers, capitalization rate conditions and property fundamentals play a role in the decision for prepayment on a property that might be sold. Carefully evaluate your prepayment options and engage qualified, experienced help to make and execute the optimal loan prepayment decision.
Michael Shelton is President and CEO of Shelton Business Services which provides executive coaching, management consulting and financial services. Call 602.463.1199, email [email protected] or visit sheltonbusinessservices.com Advancing business ability with our proven executive coaching, objective management consulting and dependable financial services.
Broker Boarding: Six Answers You Need From Your Commercial Real Estate Mortgage Broker
The search for commercial real estate financing can be challenging during good economic times and capital torture in economic downturns. A commercial real estate mortgage broker can uncover sources of debt capital after your lending relationships are exhausted. But there are six essential questions that must be answered before you hire someone to find a loan.
Do you have relevant experience? You want a broker that is an expert in your category of commercial property. A commercial real estate mortgage specialist in multi-family properties is not necessarily the best choice to find a loan for your shopping center. Some brokers claim to have expertise in all property types and wide spectrum access to capital. While that may be true for some of the large commercial mortgage brokerage shops it can be an overstatement for an individual broker. Look for an experienced broker who is intimately familiar with the challenges and solutions for your property type.
How wide and deep is your portfolio of lenders? The primary reason to hire a commercial real estate mortgage broker is for access to their list of potential lenders. Your stable of relationship lenders may not have the appetite or capacity to meet your borrowing needs. A mortgage broker may have lending sources that are not on your radar. Your broker should know who is lending in your situation and have a broad and deep list of potential capital sources. Obviously there may be some overlap with your lending relationships and you don’t want to pay a fee to a broker for someone you can go to directly for capital.
How much and by whom are you paid? A mortgage broker is usually paid by the borrower, not the lender. Ask your broker for a schedule of their fees and be sure they are spelled out in your engagement agreement. The biggest fee will be the loan origination fee which is often expressed as a percentage of the loan amount. Make sure you shop around for competitive fees among brokers but keep in mind the level of service and support you expect to receive. Discount fee brokers are not always the best choice. You usually get what you pay for. You are paying a fee for someone to find a loan. Keep in mind that brokers are salespeople first. Practically speaking, not from a legal perspective, the broker gets paid if a new loan is funded. Many brokers are reputable but be aware of the potential conflict of interest when evaluating advice from your mortgage broker.
What kind of support staff do you have? Your broker will represent you in front of lenders and be the salesman for financing your property. Large brokerage firms have a deep bench of support staff to help the broker find a lender and then close the deal. The key players on a loan transaction team include a financial analyst, market research specialist and the loan administration or servicing specialist. Avoid hiring a broker with limited resources who will lean on you for presentation materials, financial modeling and closing checklist management. These are services that should be provided by your broker. A full service mortgage brokerage firm will have these services but may charge a larger fee to cover their overhead. You will balance cost versus service when deciding which broker to hire.
Will you service the loan after it closes? You may benefit from a mortgage broker who rolls into loan servicing functions after closing. The originating lender may have an existing arrangement with the broker to provide loan servicing for a fee. You benefit from continuity of service with a familiar name to call if you need help during the loan term. But be aware of the potential conflict of interest if your loan closes with a lender for whom the broker provides loan servicing.
Are you demanding an exclusive period? Service providers love a protected market. Borrowers in exclusive handcuffs can miss capital market opportunities. Brokerage agreements can contain exclusive periods where the borrower promises to stand down on any search for financing while the broker is engaged and for a specified period after the engagement. Carve out your right to conduct capital market activities for your other properties and corporate credit needs. Be careful with exclusive rights. There is no guaranty a broker will succeed in finding the right loan for you. You could be standing still for months while your maturity date gets closer and the financing market shifts for or against you.
Mortgage brokers can be incredibly helpful allies in the placement of commercial real estate debt. But get satisfactory answers to these important questions before making a broker hiring decision.
Michael Shelton is President and CEO of Shelton Business Services which provides executive coaching, management consulting and financial services. Call 602.463.1199, email [email protected] or visit sheltonbusinessservices.com Advancing business ability with our proven executive coaching, objective management consulting and dependable financial services.
Business Finance Fundamentals: Five Factors For Lower Loan Interest Expense
Your interest rate is a key loan term. How is it determined? How can you pay the lowest possible interest expense?
Why does the interest rate matter? The interest rate determines your loan payment. A lower interest rate equals less loan interest expense. Also, the loan size is limited in part by the debt service coverage ratio which is calculated using the annual loan payments. The smart borrower understands the critical role and components of the commercial loan interest rate when evaluating financing.
Fixed or floating? A fixed rate loan has a constant interest rate used to calculate the periodic loan payment. The constant payment can give the borrower confidence in capital planning with a known debt service requirement. A floating rate loan uses a variable index such as Prime or LIBOR (London Interbank Offering Rate) to calculate the loan payment. The floating index resets from time-to-time according to the terms of the loan agreement. A floating rate loan typically has a lower interest rate compared to a fixed rate loan. However, the annual budget for debt service is difficult to determine with accuracy since the rate can fluctuate. There are many ways to control floating rate exposure through LIBOR fixes and interest rate caps and swaps. Choose fixed or floating to match your needs.
The interest calculation method matters: Lenders use different methods to calculate the amount of interest that accrues during a period. One popular method takes the actual number of days in a period, for example a month, and divides it by a 360-day year. This calculation naturally provides a built in profit for the lender because there are five extra days of interest, six in a leap year. A standard calculation among life insurance companies is the 30/360 method which uses twelve 30-day months over a 360-day year to calculate interest. This method ultimately returns 100% of the annual interest but the interest accrual in short months works to the benefit of the lender and long months are in favor of the borrower. Fixed rate loans have a constant payment but the amount of interest applied to each payment can vary depending on the method used to calculate periodic interest. Pay attention to the calculation method when choosing a loan.
Know the components of the all-in rate: The index is the base layer used to calculate interest. There are many indexes used in lending. The most common are the bank Prime lending rate, LIBOR, and United States Treasury notes. Floating rate loans tend to use Prime or LIBOR as the index while fixed rate loans are typically priced using Treasury rates. Lenders address the increased default risk premium above Treasuries by using the swap rate. The Treasury index plus the swap spread (default premium) is the swap rate to which the lender adds the borrower’s credit spread. The credit spread is unique to a particular borrower and takes into account the collateral, borrower sponsorship, credit history, market conditions and other factors. The lender’s credit committee determines the borrower’s credit spread. The index and the credit spread determine the all-in loan interest rate used to calculate the periodic payments.
Learn to burn down your spread: Some lenders are willing to reduce the floating rate index or the fixed rate of your loan after you meet certain performance conditions. For example, a construction lender might reduce your loan spread after completion of construction. Other triggers for an interest spread reduction may include achieving a certain debt service coverage level or improving the value of the collateral. Be aware of triggers that will cause the interest spread or rate to revert or claw-back to the original level. Ask for an interest rate or spread reduction hurdle during loan negotiation to potentially lower your future debt service payments.
Ask for interest-only payments: Some lenders are willing to write loans that have all or part of the loan term on an interest-only basis. A conventional loan has periodic principal and interest payments which amortizes the principal balance over time. An interest-only loan defers repayment of principal until sometime later in the term, many times until the maturity date. The periodic loan payment is lower because the principal component is deferred. Your cash flow is greater because of lower debt service payments but the principal balance must be repaid later so be prepared with take-out financing at maturity.
You can lower your loan interest expense by paying close attention to the interest rate structure. Be a shrewd businessperson by negotiating favorable interest rate terms in your loan agreement.
Michael Shelton is President and CEO of Shelton Business Services which provides executive coaching, management consulting and financial services. Call 602.463.1199, email [email protected] or visit sheltonbusinessservices.com Advance your business ability with our proven executive coaching, objective management consulting and dependable financial services.
The Lender Yes: Six Keys To Unlocking A Successful Commercial Loan Modification
The loan maturity is speeding towards your business like a freight train. The rumble in the debt tunnel is growing louder and there is no takeout financing available. Maybe you lost a key client or other revenue source that has derailed your ability to make the monthly loan payment.
You need debt relief! Your mind races through loan workout and acceleration scenarios. So you reach for the phone to call your lender and ask for some form of loan modification. Wait! Before you dial consider these critical issues and make a workable plan to increase your chances for a successful loan modification discussion with your lender.
Know where you stand. Many borrowers seeking debt relief are in a weak negotiating position. However, just because you have a cash crunch doesn’t mean you have no leverage. The lender might highly value its relationship with your company and is willing to move mountains to keep your future lending business. Your bargaining position is stronger if you have other banking business such as cash management agreements. Your lender might be reluctant to repossess collateral for many reasons. Banks and other money sources are in the lending business and not eager or knowledgeable to run your business. There’s and old saying that he who wants it more gets less. Identify the reasons your lender is anxious to keep the loan on its books with a successful workout.
Mean what you say and say what you mean. Sometimes discussions take a heated turn for the worse. Try to keep the conversation respectful and focused on a solution. Make a stand if necessary and only make threats or promises you are prepared to carry out.
Make the maturity date work to your advantage. An approaching deadline naturally increases the urgency of the parties. Take your workout proposal to your lender with enough time to negotiate and document the agreement prior to the loan maturity date. Don’t go too early though. Your lender may be overwhelmed with other borrowers depending on the credit cycle and bury your request in the pile. Submit your proposal three to six months prior to the maturity date for maximum attention.
Bring a solution. Your relationship manager often wants to be your advocate before the credit committee. You can improve your chances of a successful credit approval process by having a well constructed loan modification plan. Don’t rely on your lender to craft the details of the modified payments, maturity date extension, re-margin payment, or the loan-to-value and debt service coverage thresholds. Help them understand your plan to reposition the collateral for future take-out financing.
Who is your debt master? The owner of your loan holds the modification decision in its hand. Are you dealing with your original relationship lender or has your loan been securitized? A master or special service has strict regulatory requirements to follow so is generally more limited in what consent they can grant. On the other hand your originating lender wants an orderly takeout plan and has more discretion to grant waivers and modifications. Subordinate investors may have disproportionate control over a securitized pool. Loan servicers may own subordinate pieces of the pool creating a potential conflict of interest. Bottom line, it will generally be more difficult to work through a securitized servicer than through your friendly relationship banker. Know the adversary you face.
Know the limits of your generosity. The lender will expect valuable sacrifices from you during the loan workout discussion. Be prepared to accept more reserves for debt service, capital expenditures, operating expenses, property taxes and insurance among others. You may agree to stricter cash management including a hard lock box, cash trap conditions and an allocation waterfall. Be prepared to write a check for principal reduction and provide additional loan collateral. Some lenders will require new or additional loan completion and repayment guarantees. You must understand the additional financial exposure from each concession and weigh it against the benefits from lower loan payments or an extended maturity date. A release provision should be negotiated for many concessions. For example, if the borrower agrees to stricter cash management the trap and waterfall provisions should be released at some reasonable debt performance hurdle such as a minimum debt service coverage.
A well designed loan modification can help the borrow live to pay another day. Other times the concessions are too heavy and accelerate a critical borrower condition leading to bankruptcy or foreclosure. Be prepared with a strategic borrowing plan before calling your lender.
Michael Shelton is President and CEO of Shelton Business Services which provides executive coaching, management consulting and financial services. Call 602.463.1199, email [email protected] or visit sheltonbusinessservices.com Advance your business ability with our proven executive coaching, objective management consulting and dependable financial services.
Does Your Business Need A Loan: Several Tips To Help Your Business Get A Loan
Does your company need financing? If so a loan is the answer. Here are a several ideas to make the process a little easier and less painful. Start off thinking about a loan for your company right away, don’t delay until the last minute. Plan ahead. Forecast how much money you’ll need for the upcoming 6 months and revise it at the end of each month. Do not procrastinate until you’re running out of money to commence applying for a fast business loan.
Get the financial statements for your firm in place even if your firm doesn’t need a small company credit line right now. All the records including: accounts payable, accounts receivable, and an income statement, as well as balance sheet should be kept up to date. Keep these records current on a regular basis and it won’t be a challenge to get them ready for the creditor.
Obtain a credit line for the business immediately. The credit could be simply a store account, mail service account or even a company credit card. Use the loan and make prompt payments. After 6 months or so you will have established a track record. Your business should be reviewed as an excellent risk for a loan by lenders.
When requesting a loan your personal assets will be pledged to guarantee the firm’s loan. Bankers demand this to ensure the loan is secure. Your spouse’s property will be required to guarantee the debt as well, even if your spouse isn’t involved in your business.
Do not be surprised if the lender also requires that your business opens an account to guarantee the loan. The balance in the account may not be available.
Other covenants the lender may put on the business is not getting any additional loans, restricting bonuses for management and keeping the cash flow positive.
When small companies apply for a loan, lenders review the credit worthiness of the principals. Keep a strong credit profile.
Lenders demand to see that the business meets three requirements. The company has an established credit history. The business has enough funds to repay the loan and your business will earn enough cash during the term of the loan to pay the interest. If the company is new, the creditor also considers the credit worthiness of the owners.
Follow these tips and general principals and you’ll soon be able to obtain credit or a loan from your bank, lender or creditor to get your business off to a great start or expand it.
Corey Landis contributes to several websites on the subjects of how to small business financing and how to write a press release.