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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   October 2006

How to Structure a Tough Loan

Look to one of these five structures when financing a challenging scenario

A successful income-property investor you’ve worked with on three purchase loans calls you, excited about a new prospect.

“I’ve found a 24-unit apartment building,” she says. “An elderly couple have owned it for years. Rents are way below market. It’s on the market for $2 million. Can I get the loan?”

Your client has discovered a property that has not changed hands in many years. As the owners got older, they reached an informal arrangement with their tenants — the landlords wouldn’t raise rents too much and the tenants wouldn’t call every time a light bulb burned out. Over time, however, the property-income lagged increasingly more behind the rising market.

You run the underwriting drill. Your conclusion is that there is a shortfall between the amount the client is putting down and the loan size the property’s cash flow will support.

It’s a classic problem with tough loans — a below-market property income. In this case, it’s because rents are low. In other cases, it may be because there are an excessive number of vacant units or because the occupied units are not producing the maximum possible income — or a combination of these factors.

This property is considered an “opportunity property” because there are ways the owners could increase the cash flow. The current loan size will be based on today’s positive cash flow, however. As such, this property doesn’t yet have the net income to support the target loan size.

How can you get this loan funded? Your answer might be found in one of these five ways to structure and finance a tough loan.

1. The seller carry-back

One way to structure the purchase of an opportunity property is for the seller to carry back a second-position mortgage. Sellers are often willing to finance 5 percent to 15 percent of the purchase price by taking a junior position behind the first mortgage. This is because the seller may be getting a premium price for the property or may be motivated to close quickly.

The buyer typically will have to make a 15-percent down payment at a minimum. And the interest rate on the seller-second will probably be more than the interest rate on the first. Further, lenders usually have underwriting guidelines that include not only a minimum debt-coverage ratio (DCR) or debt-service-coverage ratio (DSCR) for the first mortgage but also a combined DCR/DSCR for the first and the seller-second.

Standard conditions vary, but seller carry-backs often have a minimum five-year balloon term, interest-only loan payments and rates ranging from prime to prime plus 1 percent or 2 percent.

2. Cross-collateralization

A cross-collateralized loan is one in which the lender secures not only the subject property but also one or more other properties.

Consider the aforementioned transaction example. Your client purchased her first apartment building four years ago. She has managed it well, and the positive cash flow is significantly higher than when she bought it. Because she owns this other successful income property, the lender may consider making a loan with low or “break-even” debt coverage if this additional collateral is available.

The key here is that the additional collateral must be income property — because the gap lender will underwrite the loan factoring in the positive cash flow from the additional collateral.

This structure has the advantage of being efficient in terms of time and cost. Usually, its primary cost is the fee for the additional collateral’s property appraisal.

3. The hold-back


Most lenders will not fund an income property with significant deferred maintenance. Those repairs must be made, however. So what can be done if the property-seller doesn’t want to replace the roof or repave the parking lot? 

If a new roof is going to cost $20,000, the lender typically will hold back 125 percent of the amount of the accepted bid for the work. After the work is completed and verified by an inspection, the held-back funds will be released to the borrower.

This structure will cover a relatively small shortfall (roughly 10 percent or less of the initial loan amount) between what your client requires and what the property will currently support.

4. The earn-out

This option works when the current rents are significantly less than the local market rates.

Lenders will initially fund the loan amount supported by the property’s current operations. The buyer must come in with a larger down payment, and lender holds the unfunded loan balance.

Rents are often low because of the property’s condition. Thus, lenders usually will give the new owner six to nine months to complete any required renovation work and to start leasing at higher rents. After three to six months of successful occupancy, and once the property’s operations meet the required DCR, the lender releases the earn-out account monies to the borrower.

The specific terms of the earn-out structure are negotiated upfront and detailed in the loan documents.

5. The bridge

This structure, which is similar to a typical construction loan, can be employed when major property renovation and rehabilitation work are necessary.

Lenders are generally willing to loan between 70 percent and 80 percent of the project cost. There are three components of project cost: 

  • The property acquisition;
  • The cost of rehabilitation/renovation work; and
  • The interest reserve established at loan closing to make the monthly interest payments while the work is under way.

The lender will want the full financial contribution from the borrower at the close of escrow. After the property purchase, the borrower begins the work according to the agreed-upon project plan and budget. Meanwhile, the lender funds monthly draws.

Vacant properties, properties underperforming because of serious maintenance issues, and properties that need to be repositioned to better address local market demands are all prime candidates for a bridge structure.

•  •  •

Every successful commercial real estate professional knows it is essential to be knowledgeable about loan-product guidelines and rates. The next necessary step is to know how to take that knowledge and craft it with individual scenarios to close difficult loans.



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