1. Chapter 19 Permanent Financing of Commercial Real Estate Properties © OnCourse Learning

2. 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 © OnCourse Learning 2

3. 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) © OnCourse Learning 3

4. 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 © OnCourse Learning 4

5. 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 © OnCourse Learning 5

6. 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 6 © OnCourse Learning

7. 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 statements Selling 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. 7 © OnCourse Learning

8. 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 © OnCourse Learning 8

9. 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 © OnCourse Learning 9

10. 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. 10 © OnCourse Learning

11. 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 © OnCourse Learning 11

12. 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 © OnCourse Learning 12