Conduit Lending

David Smyle Comments
Posted in Articles, Finance, Insurance
Print

For self-storage, most of the long-term, fixed-rate financing (10 years or longer) is provided by the Wall Street “conduit” market also known as “securitized” lending. These loans are originated around the country collateralized by various property types, pooled together in very large amounts, packaged and sold to investors by Wall Street firms as commercial mortgage-backed securities (CMBS). The minimum loan accepted is $500,000 with most program minimums starting at $1 million. It typically takes 45-60 days to close most conduit loans.

While these loans offer attractive rates (5.8 percent to 6.5 percent—on August 31, 2006), rates vary depending on loan size, loan-to-value (LTV) and debt-coverage ratio. Qualifying is sometimes difficult, especially for properties experiencing any of the following:

  • Less than stabilized occupancy 
  • Newly built 
  • Rural location 
  • Minimal amenities or dirt/gravel driveways 
  • Poor operating history 
  • Negative market influences (overbuilding, population outflow, job losses, military base closures, etc.)

Generally, the conduit market underwrites loans to a maximum 75 percent LTV, but can go up to 80 percent using the trailing 12 months cash flow, including ancillary sources of income such as late fees and incomes from RV parking, storage and truck rental. A property in lease-up may have stabilized occupancy (85 percent to 95 percent), but may not have had enough cash flow over the past 12 months to qualify for higher LTV requests. For additional leverage, mezzanine financing up to 85 percent combined LTV may be available, but the additional 5 percent leverage comes with much higher rates and ties up property ownership until the mezzanine portion is paid off.

The Highs

Main attractions of conduit financing are threefold. First and foremost, rates for a 10- to 20-year fixed are untouchable by most other commercial financiers. Spreads of basis points (bps), also known as margins, are in the 110 bps (1.1 percent) to 150 bps (1.5 percent) range. The overall rate is determined by adding the spread to the current corresponding Treasury bill. For example, for a 10-year loan term with a 125 bps (1.25 percent) spread, adding the spread to a corresponding 10-year T-bill yielding a 4.74 percent rate results in a 5.99 percent overall interest rate.

Also attractive is the long amortization of up to 30 years and the possibility of interest only as long as the full term of the loan. This lures investors looking to maximize cash flow. A nice feature of a conduit loan is you can lock interest rates any time during the loan process. To do so the borrower must put down 2 percent of the loan amount as a deposit, which is returned at closing.

Finally, conduit loans are favored because they’re non-recourse, meaning, if there’s default or foreclosure, the lender can recover principal and interest losses through foreclosure. The borrower’s personal assets are free from judgment or collection due to the lender’s losses with one caveat: He has to sign a document guaranteeing the loan for “non-recourse carveouts,” designed for fraud, waste, mismanagement, misrepresentation and environmental contamination. If the borrower is guilty of any of the above, his personal assets are at risk.

The Lows

While conduit loans offer very low fixed rates and are generally non-recourse, they do carry several disadvantages, such as they often incur stiff prepayment penalties tied to yield maintenance or defeasance, which can easily run six figures in the wrong interest-rate environment. Penalties are determined by comparing the loan’s note rate to the “remaining term” T-bill on the payoff date.

For example, seven years into a 10- year loan at a 6 percent rate, we’d compare the then three-year T-bill to the note rate. If the three-year Treasury yielded 5 percent at that time, the lender would lose 1 percent over the remaining three years because they’d reinvest the loan proceeds in a remaining term Treasury yielding less than the Note rate—to pay investors in the CMBS pool. If the three-year Treasury yielded more than 6 percent, a penalty would depend on the prepayment language; some have a minimum of 1 percent regardless of a higher T-note. This is a very simplified explanation. Basically, prepayment penalties are an unknown but probably insignificant if funded under current rates.

Another drawback: Second trust deeds or mortgages aren’t allowed. If a borrower wants to pull cash out of the property, he’d have to refinance—potentially paying a prepayment penalty—or obtain a mezzanine loan at higher rates, tying up ownership. Mezzanine lenders secure loans by an interest in ownership versus real estate collateral. Borrowers wanting to add units will have to build them out-of-pocket because conduit lenders won’t allow construction loans behind their first mortgage, nor will most construction lenders fund behind someone else’s first. Conduit lenders dislike expansion projects because potential construction liens could affect the title.

Conduit loans often impound for taxes, insurance and future replacement reserves although they can be waived or capped on lower LTV transactions. This reduces monthly cash flow and doesn’t sit well for borrower’s who prefer paying taxes and insurance on their own time. The impounded replacement reserves are for capital improvements, but carry a small administrative fee.

Also on the downside, conduit loans usually require higher liability insurance minimums and extra coverage not typically carried, such as terrorism insurance. Title insurance costs are often higher because of extra endorsements required by conduit lenders.

Borrowers that are a single asset entity (SAE) or single purpose entity (SPE)—versus an individual or trust—are preferred by lenders. An example of an SAE or SPE is an LLC, partnership or corporation. The rate for individual borrowers is usually higher by five to 10 bps to account for the additional lender risk.

In addition to the standard appraisal and phase one required by most traditional lenders, conduits require an engineering report assessing maintenance and capital improvements over the loan’s life—for determining necessary impounded replacement reserves. Most conduits also require an ALTA or “As Built” survey. Surveys cost $3,000 to $8,000.

Appraisal, environmental and engineering reports cost $12,000 to $15,000; paid separately, lender’s legal fees run $7,000 to $10,000. Borrowers must hire an attorney ($1,500 to $2,000) to prepare an opinion letter confirming the accuracy and borrower’s authority and capacity to execute the documents.

Lender application fees range from free to $5,000. With nearly two dozen different conduit programs from which to choose—featuring different requirements, minimum loan amounts, fees and spreads—plan to shop through an experienced commercial mortgage banker or broker to find the best deal.

Lastly, application processes vary, but many request copies of bank statements, deposit records, utility bills, tax bills, insurance premiums, rent rolls, operating statements, occupancy reports, borrower financial statement, tax returns and borrower resume.

The Decision

A 10-, 15- or 20-year term at fixed rates in the high-5 percent to low-6 percent range can be worth upfront and closing costs for long-term property holders. Ten-year loans carry up to a 25- to 30-year amortization, while periods exceeding 10 years are generally self-amortizing (i.e., a 15-year fixed-rate loan will have a 15-year amortization). However, if you want to avoid prepayment penalties or need a short-term loan, banks, savings and loan associations, credit unions and insurance companies might be your best option.

While borrowers can work directly with conduit lenders without a mortgage banker or broker, the process can be difficult. Learn loan terms, closing requirements (insurance, title endorsements, etc.) and make checklists. Obtain a sample copy of the conduit lender’s loan documents before paying upfront cash. Conduits routinely use mortgage professionals to originate loans and thus do not charge a loan fee—allowing the mortgage professional to collect the loan fee instead. So an experienced banker or broker can be yours for the asking; you won’t incur extra loan costs but you’ll have an expert to guide you through the process. 

David Smyle is president of Benchmark Financial, a commercial mortgage banker in San Diego. For more information, visit www.benchmarkfin.com

Comments
comments powered by Disqus