February 23, 2009

Alternative Financing Structures for Real Estate Deals

The credit markets continue to be "cool" if not frozen. Accordingly, many property owners and developers are considering alternatives to traditional financing structures to allow their deals to go forward. Three such alternatives are seller-financing, sale-leasebacks and ground leases. The following describes each of these structures, when they might be considered, and a few pros and cons.

Seller Financing

If the buyer of real property cannot secure traditional financing, a seller might consider financing the sale. For example, instead of the seller receiving the full purchase price at closing (for example, $1,000,000), the seller would receive some cash as a down payment and the remainder payable over time. Occasionally, this transaction is structured as a contract for deed (or "land sale contract" in some jurisdictions), which is a contract between buyer and seller pursuant to which the buyer promises to make payments over time and receives the deed transferring the land only after completing all payments.

After making the initial payment but before making the last payment and receiving the deed, the buyer is allowed to take possession of the property even though the seller remains the record owner. In the alternative, the seller could convey the property by deed upon the initial payment and take back a promissory note secured by a mortgage lien on the property, just as a traditional lender would do. The payment terms would be the same whether a contract for deed or seller note and mortgage were used.

A contract for deed requires a few considerations. First, from the buyer's perspective, a contract for deed does not provide the same redemption rights that a mortgage would. In Minnesota, if a buyer misses a payment under a contract for deed, the seller can provide a statutory notice of cancellation and take possession of the property unless the buyer cures the default within 60 days after the notice. With a mortgage, a seller must typically publish notice of a foreclosure sale for six weeks prior to the sale, and a buyer would typically have six months after the sale to redeem its interest in the property (i.e., "buy back" the property at the price bid at the foreclosure sale, plus costs). Of course, the flipside is that the seller would prefer the abbreviated cure period under the contract for deed.

On the other hand, with a contract for deed, the seller remains the owner of the land and is at risk for buyer's actions during the period of buyer's ownership. For example, if the buyer is improving the land, unless certain steps are taken (such as posting prominent notice on the property), the property could become subject to mechanic's liens for the amount of the construction work. If the buyer does not pay these liens, the seller would have to pay them or risk losing the property if the mechanic's liens were foreclosed. If the seller had taken a promissory note and mortgage from the buyer, the seller's mortgage could have priority over the mechanic's liens caused by the buyer, and the seller would not be at risk of losing the property as security.

Sale-Leaseback Transactions

Sale-leaseback transactions are an approach for companies to convert real estate assets into cash without disrupting current operations. A typical sale-leaseback involves conveying property occupied by a single user to a firm that specializes in owning such properties, followed by a lease of the entire property back to the user. The user receives a purchase price for the property, which is often the rough equivalent of the present value of the stream of rent payments that the user must pay (plus a reasonable return on the investment).

For many companies, entering into a sale-leaseback provides capital that would otherwise be tied up in the ownership of real property, and allows such capital to be used for acquiring distressed properties, expanding the business, marketing, and similar matters. But there are pitfalls to be avoided.

Perhaps the most significant risk for both buyer/landlords and seller/tenants is the risk of recharacterization. In a recharacterization, the IRS or a bankruptcy court determines that the sale-leaseback is really a "loan" made by the buyer/landlord to the seller/tenant. This result could occur when the amount of "rent" payable over the lease term is exactly equal to a repayment of the "purchase price" plus a reasonable rate of return, and (most importantly) when the seller/tenant has the option to re-acquire the property at the end of the term for a nominal amount. In such a case, the IRS might claim that the transaction was designed to cheat the IRS out of taxes (because the seller/tenant has the right to claim a deduction for rent paid, but not for the principal amount of any loan repayments); and a bankruptcy trustee trying to increase asset value of a bankrupt seller/tenant would assert that the documentation was done to inappropriately pull assets away from the seller/tenant and give far faster and easier remedies (eviction, rather than mortgage foreclosure) to the buyer/landlord.

Sale-leasebacks are not always the best choice for real estate held by an operating entity. Properties that operating companies must continue to own or control indefinitely may not be appropriate for a sale-leaseback. The seller/tenant needs to understand the real risk of losing the property. A sale-leaseback works better with more fungible real estate, such as single-use chain restaurants on pad sites. In addition, companies often focus more on the purchase price that will be received, rather than the rent obligation created in the lease. The buyer/landlord will view these as related, and to the extent it offers a higher purchase price, it will likely recoup that higher price with rents that may be significantly above-market. Buyer/landlords in such transactions should keep in mind the risk in a bankruptcy, when a bankruptcy trustee could selectively reject certain leases, regardless of the large purchase prices paid for those properties by the buyer/landlord just a few years before the bankruptcy filing.

Ground Leases

Real estate developers can use a long-term ground lease to gain long-term possession of a development site without raising the money needed to buy the site from the existing owner. Most often, a ground lease is a lease of undeveloped land for a very long term (e.g. 50 or 99 years), often with several renewal options. The tenant enters the ground lease and then constructs a building. During the term of the ground lease, the building belongs to the tenant, but building ownership transfers to the landlord upon termination of the lease. Developers should consider ground leases as ways to finance the land acquisition cost of a project, thus reducing the amount to be borrowed for the overall project. Developers need to be very careful in how the ground lease is drafted because it will strongly affect whether the project is considered "financeable" by potential lenders. For instance, because the terms are so long, usually rent will adjust periodically throughout the term. But lenders like certainty so these rent adjustments may need to be subject to caps, or not begin until after the initial loan term.

Certain land owners, such as universities, hospitals, cities or religious groups, have always looked at ground leases as a way to realize economic value from land while maintaining long-term control over it. For example, they may have land adjacent to an existing campus that is underutilized, but potentially needed for expansion purposes in the distant future. Ground leases also allow the land owners to control how the land is developed and used more easily than deed restrictions. Land owners can also use ground leases for tax purposes (creating a stream of taxable payments instead of one lump sum, which may become a more common reason if capital gains tax rates are raised to the level of income tax rates). Like the developer/tenants, the land owners need to carefully consider the lease terms to protect themselves. For example, the land owner should consider design approval rights and requiring a construction completion guaranty.

The above ideas provide alternatives to traditional financing that might allow projects to begin while capital markets are slow. Each of the alternatives contain advantages, but also potential pitfalls, for those who use them. All of them should be considered by those looking to move projects forward but are having trouble obtaining traditional financing.

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