Lenders have begun to show a renewed interest in real estate and some are actively seeking to expand their loan portfolios.
Despite this resurgence of interest, one aspect that will continue to have an impact on loan terms and volume, however, is the nonrecourse feature.
In the wake of the property bust of the late 1980s, lenders recognized that taking troubled properties back through foreclosure requires them to shoulder these additional financial burdens plus all property management issues with no further recourse to the borrower. Consequently, many lenders were forced to agree to substantial modifications of loan terms and principal reductions in order to avoid repossessing properties.
Lenders now returning to real estate are looking for recourse to the borrower or the tenant as well as for collateral on the underlying property, and to a more dependable and assured rental stream.
But with respect to certain assets, such as conservatively leveraged net leased property, lenders can and do lend on a basis which is without recourse to the owner/borrower.
Such loans are supported via long-term, absolutely net leases, by the full faith and credit of large, income generating tenants and by the real estate.
There are obvious distinctions to lending with regard to net leased properties, especially where a significant equity contribution is involved. Even though these loans are customarily without recourse to the owner/lessor, often the investment manager negotiates workouts that resolve potentially expensive issues.
In the unusual case of tenant bankruptcy and abandonment, the manager often chooses to pay debt service while re-letting the property to save its equity and maintain its relationship with the lender. It is routinely provided that the long-term, absolute net lease be assigned to the lender as additional collateral.
Net leased real estate has included properties such as office buildings, manufacturing facilities, distribution centers, retail stores, fast-food franchises, and more recently, hotels.
The properties are sold and then leased back by the original owners on a triple-net basis. Net leases are usually long term with built-in inflation adjustments to the rent. The tenant pays the insurance, taxes, and maintenance on the building, hence the name triple-net lease.
The guarantee of the tenant typically backs a net lease. Consequently, the creditworthiness of the tenant is critical in evaluating potential net lease investments from the lender's as well as the owner's point of view.
What should a lender look for when evaluating a loan against a net- leased property?
Of crucial importance is the financial strength of the tenant. The equity investor and the lender should both have a strong interest in this factor.
With a knowledgeable owner and lender both reviewing the tenant's finances and industry position, credit judgments are improved, the second opinion being of great value.
The loan-to-value ratio should be a function of both the quality of the tenant's credit and the value of the real estate itself. A thorough evaluation should include local market trends, the regional economy, industry dependency, and rental rates of comparable properties. (In the case of a property leased to a tenant with a bulletproof credit rating, an 80% loan-to-value ratio could be considered conservative, depending on the structure and terms of the lease.)
A healthy ratio reduces the risk that the security provided by the underlying asset will fall below the amount of the loan.
The property itself should be critical to the tenants' business. This is important so that, should the tenant be sold or experience financial difficulties, the facility would be essential to the ongoing operations of the tenant. Even in bankruptcy, the tenant will usually pay full rent upon an essential property, since it must in order to retain possession.
Binding lease terms are equally critical. The lease should provide that the tenant guarantees all lease payments. Additionally, should the tenant be sold or taken over, covenants should provide for approvals of ownership changes by the landlord and the assumption of the guarantee obligation by an equal or stronger credit.
Other covenants and special provisions a lender should look for include protection against payment of excessive dividends, a change of control of the tenant, incurrence of additional indebtedness, environmental and legal violation, and other similar matters. Ideally, the term of the lease should be 15 years or longer to allow for meaningful amortization while still generating cash flow to the investor.
The owner/portfolio manager should be an experienced net-lease investor with a track record of consistent investment performance. This track record will further assure the lender that the assets being financed will retain the characteristics of solid value collateral over time.
From the lender's point of view, an experienced net-lease investment firm should possess in-depth, in-house credit analysis capabilities as well as traditional real estate acquisition skills.
If an owner has addressed these elements with respect to the tenant, property and lease terms, the lender should feel comfortable lending against a net leased property.
Although lenders often feel they should have a personal guarantee from the owner, this is usually not customary in net-lease financing. If the tenant's credit and the property cannot combine to produce adequate security, the loan shouldn't be entered into in the first place. Anyway, history has taught us that when real estate owners get into trouble, they often do so in big way.
Consequently, their overall financial situation is affected, causing the value of any personal or corporate guarantee they may have provided to be substantially diminished. If a lender has done his due diligence prior to lending against a net-leased property, his best security is recourse to the tenant and to a solid stand-alone asset.
Over the years individual investors have found well-structured net-lease investments to be excellent long-term vehicles providing growth and steady income. More recently institutions and pension funds have begun to move in the same direction and are directing money to experienced net-lease investment managers with proven track records.
Like most real estate deals, if the owner/borrower has performed the proper due diligence and analysis with respect to the real estate and the tenant's credit, the investment will provide good long-term value for the investor/owner.
Even those lenders who were burned in the last real estate downturn would probably agree that if a property is a good long-term investment for the owner it will be a good loan for the lender.
Thus, conservatively leveraged, thoughtfully structured net-leased assets supported some of the safest, best-performing loans during the last down cycle. Lenders then active in this arena now count their blessings.
Mr. Carey is chairman of W.P. Carey & Co., a real estate investment firm in New York.