Buch the Trend — A Commercial Real Estate Blog

Fee Not So Simple – Ground Leases As A Financing Alternative

By Steve ‘Buch’ Buchwald – The Debt & Equity Finance Group

In prior articles, I’ve discussed various forms of non-traditional financing sources including HTCs, PACE, and EB-5.  As the traditional LP equity market is increasingly selective for ground up development deals at this stage of the cycle, more and more of these transactions are attempting to utilize these alternative sources to reduce the required equity.  One method often circled by developers is selling off the fee interest in the property by creating a new ground lease as a form of financing.

The concept in the eyes of these developers is simple – reduce the capital stack by the sale price of the fee interest and finance the leasehold position separately with a leasehold mortgage in order to maximize leverage.  Unfortunately, lenders see right through this and it rarely works as intended.

First of all, the lenders who are willing to lend on the leasehold position are well aware that there is little to no acquisition or purchase price in the capitalized budget, and that this is because there is intrinsic negative value created by the future ground lease expense.  Lenders will take the Net Present Value of this expense through the end of the ground lease term at a discount rate of between typically 4% and 6% depending on location.  This value is the effective cost of the land and thus increases the last dollar Loan to Value exposure of the lender.  65% LTC on the leasehold position can be as high as 100% LTV depending on terms of the ground lease.  This leads lenders to reduce their leverage on the leasehold mortgage and thus does not typically have the intended result of reducing the required equity.  Additionally, leasehold mortgage spreads are typically wider than the equivalent first mortgage.

Lenders also hesitate to lend on leasehold positions when the ground lease payments represent too high of a percentage of the projected NOI.  As the ground lease payments surpass 20% of projected NOI, there will be little to no financing options available to the borrower.

Add to these complications and constraints the fact that the developer is devaluing the property on the exit by, not only the NPV of the remaining ground lease payment expense, but also due to the leasehold ownership structure holding an intrinsic reduced market value to fee simple ownership.  Additionally, ground leases can have various escalations in them that can compound and spiral out of control over time.  This is exacerbated by maturities, fair market value resets, payment escalations beyond real rent growth, and other mechanisms or forces that may benefit the fee owner. For example, the famed Lever House in New York City is a case study of a high value leasehold asset undone by a combination of fair market value resets and remaining term.  Many other examples abound in and out of New York City.

This is not to say leasehold financing is entirely unavailable or not necessary in certain circumstances.  Certainly, if to acquire a particular parcel of land that is owned by a family or individual who wants to hold it for generational cash flow, a ground lease needs to be created to strike a deal, then it is a necessary evil that the developer must navigate.  It also can increase the depreciation tax benefits of real estate ownership relative to overall value by excluding the non-depreciable land.  If, however, it is simply a financing tool, it will not materially change the actual leverage but instead adds complexity and risk to a deal.

Mezzanine debt and preferred equity may, on their face, seem more expensive on paper.  They are, however, a far better leverage and flexibility option than a ground lease.

Buch the Trend — A Commercial Real Estate Blog

EB-5: A Thing of the Past and a Warning for the Future

By Steve ‘Buch’ Buchwald – The Debt & Equity Finance Group

So far, this blog has covered Historic Tax Credits and PACE Financing. The next topic covered is yet another alternative financing option in the form of EB-5 Capital.

EB-5 has been deployed extensively over the past decade as foreign capital lined up to procure US visas for a cool $500,000. The program was meant to spur development and the associated job creation in the U.S. for a variety of projects, but instead has led to aggravation for many developers and the EB-5 investors themselves. It is now very challenging to raise a substantial amount of EB-5 capital due to the complex challenges it has caused on both sides of the transaction.

For developers, EB-5 capital looked to be a cheap alternative to traditional mezz capital, similar to the PACE financing mentioned in the previous article. Interest rates, however, are only one part of the picture to consider when obtaining financing. Very often, our clients are focused on rate and points because economics are easily comparable between two different offers. However, funding structure, prepayment flexibility, security interests, covenants, stipulations and other terms are really what differentiate financing offers.

For example, if I lend you $20 million dollars at 6% with a 12% lookback IRR and someone else lends you $15 million dollar today at 8% and $5 million more in a year at 10%, which deal is better? The first transaction gives you more funds up front at a seemingly cheap rate but with a massive exit penalty. The second deal gives you less proceeds day one but blends to a cheaper rate despite the seemingly higher interest rate. A expert mortgage broker will model these scenarios solving for the lender IRR and advise the borrower know which deal is effectively cheaper.

Now let’s add a third alternative: I now say I can give you $20 million at 5%, but you cannot repay me at all for five years. This appears to be the cheapest of the structures mentioned and this was exactly the bait that many developers took in accepting EB-5 proceeds. This lockout however creates intractable problems:

  • What if, in year 3, of the term you want to or, worse, need to recapitalize the transaction to buy out a partner or provide more funding because you are overbudget?
  • What if you receive an unsolicited sale offer that you’d be a fool to refuse?

At that point, that 1% lower rate isn’t saving you anything, but instead costing you more than you could ever imagine. In the case where you couldn’t recapitalize the transaction, you may have lost all of your equity. In the sale scenario, you lost out on ideal timing to sell the property and make a massive profit. The 1% didn’t move the needle on returns but the structure that goes with the transaction can be a deal killer.

In addition to the 5 year lockout, EB-5 money has a variety of other problematic terms. It is an immovable piece of the capital stack. You cannot add a dollar of financing proceeds in senior to it or add additional capital that would prime it in any scenario. Because it typically comes in the form of subordinate debt (either mezzanine, preferred equity or the dreaded second mortgage), there is usually a senior loan in front of it that needs to be refinanced with the EB-5 still outstanding. This refinancing requires approval from the EB-5 provider in their sole and absolute discretion. These structural issues have made recapitalizing EB-5 deals nearly impossible, depressing deal returns due to its inflexibility. Forgoing the savings that refinancing a completed or stabilized property with cheaper capital can bring is yet another losing proposition.

For investors, EB-5 is possibly even worse. Promised a visa in a fast time frame, many EB-5 investors are still waiting. A Chinese national applying today for a U.S. immigrant investor visa may not be able to obtain one one until at least 2035. While the wait time is reduced for other countries like South Korea or Brazil, most of the EB-5 investment came from China resulting in a two-way catastrophe.

The challenges of EB-5 capital as a viable source of funding should serve as a huge warning to developers of the future in utilizing new alternative forms of financing. The economics of the capital deployed are not always worth the impact of its other terms. Cheap capital that cannot be easily refinanced, has non-traditional security, an abundance of rights and remedies, or otherwise prevents developer optionality and flexibility should be highly scrutinized and viewed with skepticism and caution.

Buch the Trend — A Commercial Real Estate Blog

The Place for PACE

By Steve ‘Buch’ Buchwald – The Debt & Equity Finance Group

(Steve ‘Buch’ Buchwald, New York, 3/25/2019) — In my previous article on Historic Tax Credits, we discussed one complicated financing structure commonly used by developers to capitalize their deals. In this article, we will discuss PACE Financing. I will do an article on several of these – a quick list includes Historic Tax Credits, PACE Financing, EB-5, and Ground Leases. Each of these specialty finance products adds layers of inflexibility to recoup equity, make refinancing decisions, account of cost overruns, and exit or refinance at attractive terms. My next article will be about EB-5, which was similarly popular a few years ago and now many developers regret the decision to take such an inflexible, difficult to deal with piece of capital just to save a few hundred basis points during construction on a small piece of the capital stack.


If you are in the commercial real estate development or financing business, I would be surprised if the term PACE Financing hasn’t crossed your desk by now. So…what is PACE? PACE stands for “Property Assessed Clean Energy”. Putting aside the minutiae of energy efficiency and what costs qualify, the key components to address are whether to employ PACE, where it lies in the capital stack, its security and repayment terms.


Before we explore what PACE really is, let me first address how it is pitched. PACE lenders have hired some amazing sales people and put out some extremely compelling materials about their programs. These materials paint a rosy picture – at the end of this article I will address how their materials could present a more balanced view – but borrowers are often drawn to low interest rate financing alternatives regardless of the potential costs and penalties down the road or across the rest of the capital stack. Like all new forms of financing, developers should be discerning and cautious. Low interest rate financing alternatives that look attractive on paper can have unintended consequences as the project progresses, particularly when it needs to be refinanced, recapitalized, or sold.



So how is PACE pitched? It is pitched as a long-term, low cost mezz alternative. Why pay 12% for mezzanine debt or preferred equity when you can get PACE for 7% fixed? However, looking behind the curtains, PACE cannot be compared to mezz in terms of security and its position within the capital stack. A PACE loan is a self-liquidating loan that is secured by a tax lien and is repaid through tax payments over a 20-year period. Like any tax lien, it is in first position, ahead of any senior lender, and it is literally on the state’s tax assessment roll. That is why some states allow PACE and some do not. But if PACE is the most senior piece of capital in the capital stack, why should it get a higher interest rate than the senior lender? Good question – it shouldn’t.


The Place PACE by Steven ‘Buch’ Buchwald, Managing Director – The Debt & Equity Finance Group

Putting PACE into your capital stack also has a potential cascade effect. If the senior is getting pushed up in effective LTV by the PACE loan, then it will either charge a higher spread on what should be a much larger piece of capital than the PACE piece would represent, effectively killing or more than killing whatever benefit it should provide over a traditional mezz loan, or it will reduce its leverage dollar for dollar at the same rate. Either way, that is not what is shown in PACE marketing materials where it looks as if the senior lender keeps its leverage the same at the same rate. Add on top of this a yield maintenance or hefty 5%+ prepay penalties that reduce in amount but go out a very long time, a reduced NOI due to the tax lien upon refinance, and other ancillary fees, one will generally find that PACE can be an expensive financing alternative, particularly as it pertains to recourse averse developers, developers with larger projects, and merchant builders or partnerships with fund LP capital that want to exit quickly.


To be clear, there is a place for PACE. If you are looking to develop a smaller scale property, desire to hold on to the property for a long time, are in a state that allows for PACE, and are employing local community or regional senior bank debt (typically partial to full recourse), then PACE may make sense. These lenders just care about their Loan to Cost and are underwriting to stabilized DSCR.


One of the perks of PACE is that the green energy aspect of it allows for a rationale to pass the tax lien on to tenants in commercial buildings through their lease or to guests at a hotel as an ancillary charge. While this does affect the end user’s effective rent or ADR, respectively, the underwriting can certainly pass muster for these local and regional bank lenders. Going back to the PACE marketing materials where the lender is pushed up in the capital stack and keeps their loan amount and rate the same – this is now a possibility – and the PACE works as intended (and marketed). It is no wonder then that almost every senior lender that has closed with PACE financing has this lender profile.

Buch the Trend — A Commercial Real Estate Blog

“An Overview of Historic Tax Credit Transactions”

By Steve ‘Buch’ Buchwald – The Debt & Equity Finance Group

(Steve ‘Buch’ Buchwald, New York, 2/5/2019) — As it becomes more and more popular to gut renovate beautiful old buildings centrally located in various markets across the county, Historic Tax Credit transactions are becoming more common.  Much to the chagrin of lenders, HTC deals have their own rules and, unfortunately, not all these transactions have identical structures.   This further convolutes what is already a very complex and esoteric intricacy to commercial real estate transactions.

So, let’s back up. Historic Tax Credits can be either Federal Tax Credits, administered by the National Park Service (NPS), or State Tax Credits, administered by the state in question.  These are based on qualified rehabilitation expenditures (QREs). While State Tax Credits can be relatively straight forward, the Federal Tax Credit rules often dictate complex org chart structures and create confusion among developers and lenders alike.

After a new set of IRS tax guidelines applicable to HTCs in 2014 were issued, the outright upfront sale of HTCs was prohibited and instead the tax credit investor had to become an investor in the transaction.  The upfront payment was capped at 25% of the purchase price of the tax credits and the investor now had to have “skin in the game” throughout the construction period.

This resulted in two different structures:

  • The Single-Tier Structure – the structure whereby the tax investor is admitted as a partner of the property-owning entity and that entity is thus entitled to claim the HTCs.
  • The Master-Lease Structure – The property owner leases the property to an entity owned at least 99% by the tax investor. The master lessee in turn obtains a 10% stake in the property owner.  While the property owner funds the QREs, it is permitted to pass the HTCs to the master lessee and thus to the tax investor through its interest in the master lessee.

If it sounds complicated, it is because it is.  Even experienced lenders often balk at having to sign a subordination, non-disturbance and attornment agreement (SNDA) with the master-lease structure, claiming they will not subordinate to anyone.  However, this is a must for HTC transactions since the SNDA prevents the collapse of the master lease structure upon foreclosure and, in turn, protects the tax credit investor’s rights to the HTCs.  These tax credits can then be used by the investor over the five-year compliance period (20% per year) after obtaining Part 3 approval (the final NPS sign-off) post-construction. During this time, any take-out financing must also agree to sign a SNDA with the tax credit investor.

Another common point of confusion is how the HTCs can be used as a source of funding.  There are generally three ways to capitalize a project with Federal HTCs:

  • A tax credit investor invests through the Single-Tier Structure and as a partner is entitled to the HTCs. This is straightforward as this investor would come in as a traditional LP partner. That said, this is incredibly rare and is not the standard for HTC commercial real estate transactions.
  • A tax credit investor purchases the HTC’s with the Master-Lease Structure and funds 25% of the HTC purchase at closing. Generally, these investors pay between 80 and 95 cents on the dollar and then 25% of this number (about 20-23% of the total HTC’s) can be used as a source of funds in the developer’s sources and uses. The remainder will typically come in over the course of the development, commonly at C of O, with some small amount held back until the developer obtains Part 3 approval from the NPS (typically 6 months or so after C of O).
  • With a tax credit investor structure similar to #2 above, the developer can then also obtain a tax credit bridge loan secured by the remaining payment stream from the tax credit investor that can be monetized up front. The amount of proceeds on the remaining 75% of the tax credit purchase net of the capitalized interest reserve and points on the tax credit bridge loan can then be added as an additional source of funds.

While these transactions are complicated, HTCs do significantly reduce the effective cost basis of renovation deals and thus are a necessary evil.  Taking the time to properly understand the HTC structures can give developers a leg up on their competitors and lenders more deal flow and higher yields.  Additionally, adding qualified professionals that understand HTCs to the development team including mortgage brokers, real estate attorneys, and tax credit consultants is a must for any developer that wants to tackle the complexities involved with Historic Tax Credit transactions.