Mission Capital’s Jordan Ray and Ari Hirt discuss the state of the current competitive financing environment, with debt and mezzanine lenders competing for borrowers.
Month: November 2016
Written by David Behmoaras, Analyst:
Encountering commercial real estate encumbered by ground leases is inevitable when pursuing acquisitions and poses challenges to lenders. We can overcome the obstacles they present to the capital markets by understanding them.
Lenders treat ground leases as financing subordinate to their loan as the leasehold lender, which has implications on how lenders analyze ground leases when underwriting the transaction. Instead of evaluating leverage on a Loan to Cost basis, lenders value the ground lease on a Loan to Value basis by factoring in the effective cost of the ground lease to the capitalization in order to determine their position.
Lenders commonly approach this analysis by calculating the NPV of the outstanding rent payments through the term of the ground lease using the prevailing market cap rate for the asset class in question as the discount rate. Lenders will add the value calculated in this analysis to the total capitalization to determine the effective cost of the ground lease and will conduct an exit analysis to assess what the risk will be on the exit. Specifically, lenders need to understand how the net present value of the ground lease payments might impact their loan’s ability to be paid down with proceeds from refinancing the asset at the loan’s maturity date.
It is important to note that most lenders will underwrite any uncertain or variable terms in the ground lease conservatively by assuming the maximum value defined in the ground lease. Key items subject to this scrutiny include fair market value adjustments and annual rent escalations (typically based on the Consumer Price Index). Ground leases with rent escalations or fair market value adjustments that are not capped will be especially challenging for most lenders because the uncertainty pertaining to the ground lease payments in the future substantially complicates the exit analysis described above. The assumption is that the take out lender will have a similar problem that is further complicated by having less term remaining on the ground lease. Negotiating caps on any and all adjustments to ground lease payment increases is highly recommended and often a crucial factor in successfully securing financing for your ground lease transaction.