The seemingly insatiable quest for greater loan origination volume is driving some capital markets oriented lenders to push beyond commodity-like conduit loans into the more specialized complex and technically demanding credit lease market.
Credit lease financing, often called CTL (credit tenant loan) financing, differs from typical conduit loans in that CTL loans are characterized by high loan to value (up to 100% LTV) and low debt service coverage (as low as 1.00 DSC) ratios. This type of high- leverage lending depends on the credit tenant's rent stream for the repayment of the underlying mortgage loan. The certainty of the credit tenant rent stream is protected by the lender providing, where necessary, lease enhancements to mitigate the risk that the tenant will interrupt rent as a result of a real estate-driven event, such as a casualty or condemnation of the property, or the failure of the landlord to satisfy its obligations under the lease.
Financing non-bond leases, i.e., double and triple net leases as credit rather than real estate through the capital markets, was made possible when Capital Lease Funding LP (CLF) developed in 1995 the first comprehensive lease enhancement structure which effectively plugs the real estate "holes" in a lease and meets rating agency requirements for a CTL loan. In January 1997, CLF securitized the first ever, rated multi-tenant pool of enhanced leases financed as credit rather than real estate. CLF's success has enticed several commodity-oriented real estate conduit lenders to jump into this niche financing market as a way of building volume for their CMBS pools.
At first glance, this increased competition should bode well for borrowers seeking the lowest cost CTL financing. In reality, having inexperienced commodity-oriented capital market lenders attempting to meet the rigorous, technical and rating agency underwriting requirements characteristic of CTL lending can pose real economic risk to borrowers.
Borrowers unfamiliar with the ins and outs of capital markets CTL financing run the risk of paying more than they think for a loan; having a loan commitment fall apart at the last minute because a particular loan provision doesn't fit with the rating agency requirements for a CTL loan; becoming enmeshed in a costly and cumbersome closing process; or being "jammed" at the closing because of so-called "surprises" in due diligence process or changes in market conditions.
In choosing a CTL lender, borrowers need to consider three primary areas: (1) the loan quoting and lease review process; (2) pricing; and (3) loan closing process. Underwriting credit tenant leases starts with the quality of the lease and credit of the tenant. Lenders who quote a spread before reviewing lease provisions against rating agency requirements for a CTL loan put borrowers at risk, since a legal review of the lease may turn up problems resulting in the lender widening spread or worse, not financing the loan. On the other hand, by doing an in-depth lease review prior to quoting a transaction, an experienced CTL lender can identify lease problems and help borrowers structure their leases and loans in a way that qualifies them as CTL loans, significantly reducing the chance of unpleasant surprises.
Given the speciality nature of the CTL market, loan pricing is more complex and subtle than the commodity-type "dial a spread" pricing of conduit loans. CTL loans are custom priced reflecting such things as credit of the tenant, deal size, debt service coverage and "best efforts" financing vs. funding by a principal. In an effort to increase actual spread, some lenders resort to a variety of "tricks" in quoting loans. For example, what base rate index a lender quotes over, i.e., interpolated, swap curve, 30-year Treasury, trailing 10-year Treasury, can effectively add five, 10 or even 15 basis points to a spread without a borrower knowing it. Also, the number of days on which interest is calculated can add to spread. By quoting interest as calculated on a 360-day year but requiring that it be paid for actual days elapsed (365), so-called Actual 360, can add between up to 16 basis points to a loan. Another "hidden cost" borrowers should be aware of is lease enhancement insurance. Many lenders expect the borrower to buy this type of insurance effectively adding seven to 25 bps to the quoted spread. Beyond these pricing subtleties borrowers need to be aware of fees and loan provisions that enable the lender to round interest up 1/8 of a point.
The next potential pitfall facing CTL borrowers is the efficiency of the lender's loan closing process. Closing CTL loans which eventually will be securitized leaves little room for error and is different from closing a typical real estate loan. Borrowers need to consider the lender's experience in closing these types of loans as inexperience can lead to considerable added cost to the borrower and the risk of being "jammed" at the closing table.
How can a borrower be protected from these types of risks while at the same time ensuring themselves that they are getting the best financing for their credit tenant property? While there is no one answer to this question, borrowers can reduce the potential of costly miscues by:
* Ensuring that the CTL lender they deal with has in-depth expertise in underwriting CTL loans and sufficient staff to provide the level of service required to underwrite and close a CTL loan. Borrowers can avoid unpleasant surprises by having the lender explain their duediligence and loan closing process in a clear and concise manner.
* Assessing how important CTL financing is to the lender. If the primary business of the lender is conduit real estate financing, a borrower is not likely to receive the service, guidance and structuring assistance they would from a full-service CTL lender which employs full-time (as opposed to using part-time employees) a dozen or more CTL experts. Dealing with true CTL underwriting experts minimizes the chance that the lender will "discover" a problem lease provision that causes them to change the deal or not fund the loan.
* Analyzing different lenders' quotes on a true "apples to apples" basis rather than focusing primarily on spread. Here, being represented by a mortgage broker or correspondent knowledgeable in credit tenant lending can be a plus.
* Working with lenders who offer a wide breadth of lease enhancement and CTL financing programs. In this way, borrowers can have the best chance of having their leases structured in the most economical way that best meets their particular requirements.
Bottom line - CTL financing is a highly technical specialty business which does not easily lend itself to a commodity financing mentality. As conduit-type real estate lenders hungry for product attempt to gain incremental volume by entering the CTL market, borrowers may find themselves being seduced by "low ball" quotes or loose underwriting standards, but as the old saying goes "if it seems too good to be true ... it probably is." To avoid the risk of unpleasant surprises, borrowers should make sure their lender has the expertise, dedication and staffing to provide the high levels of service required to structure and close CTL loans.