Real Estate Capital Basics – Interim Loans
As the name implies, Interim loans bridge the gap between short-term and long-term loan – financing in the “interim.” Interim loans extend funding options to owners with shorter-term funding needs beyond a few months. Most interim debt features terms of three to five years. Flexibility is the common denominator including liberal prepayment, drawing upon additional funds and modifying collateral requirements. Interim fundings are ideally suitable for acquiring and repositioning properties; physical upgrading and short-term hold for value creation are prime examples.
The most traditional forms of interim debt are credit lines provided by banks. Borrowers acquire properties based on their credit relationships. While the financial institution may underwrite the property acquisitions using specific formulas, borrower financial strength and repayment commitment override any real estate issues. The loan may still secured by the real estate, but the borrower often provides personal guarantees, ample equity and additional collateral to cure any property-level concerns. Secured credit lines are usually priced over LIBOR, Bank Prime or other shorter-term, floating rate indices.
Unsecured credit lines are common to larger institutional borrowers such as REITs and other public companies. These sponsors provide corporate-backed guarantees rather than at the entity level. In other words, these loans are corporate debt obligations.
Given the short-term horizon, interim loans often are prepayable with minimum, or no, prepayment penalties. Since value-creation is tantamount in interim lending, most loans accommodate additional funding during the term. The loans may be directly funded or credit enhanced. Payment formats include fixed and floating-rate, accrual and guarantee fees. The most common interim fundings are Accrual Loans and Standby Commitments.
Accrual Loans
Accrual (aka Bow Tie, Negative Amortization, Reverse Payment, Step-up) are interim debt vehicles with some type of deferred interest and principal repayment. These loans allow “pay as you go” by cash flow to accrue. Often times, such loans feature floating-rate debt yields with fixed-payment schedule. Accrual loans carry floating interest rates pegged to LIBOR, bank prime rates, treasuries, or any other similar shorter-term indices. Although interest rates float, payment schedules remain fixed. Throughout the loan term, rate fluctuations above the fixed-rate payment schedule determine the amount of accrued interest that is added to the loan balance as negative amortization.
Accrual loans are characterized as “permanent construction loans” sharing elements of both construction and permanent loans. As with a construction loan, interest costs are based on short-term floating rates. As with a permanent loan, periodic payment schedules meet minimum fixed-rate disbursements. In addition, these loans may occasionally extend seven years or more and are sometimes referred to as “mini-perms”.
In contrast to regular fixed-rate mortgages, lenders opt for accrual loans because yields are protected against mortgage market fluctuations. Borrowers are also protected by predictable debt service payments, with excess payments accruing rather than paid from current cash flow. Additional payments are postponed until loan termination, helping project repositioning efforts.
Accrued interest payments are computed according to two formats: (1) a predetermined interest rate or (2) a spread above a standard payment rate. Based upon the index or spread, the deferrable accrual may be set at funding or float during the loan term. If a floating accrual is selected and the float is a significant spread between the fixed base rate and the total interest yield, an unreasonably large interest accrual is possible. Project cash flows and corresponding value increases are required to service a larger debt load; the risk of loan default rises and refinancing problematic.
As with any income-property loan, existing and projected project cash flow behavior is the most important consideration in structuring deferred interest payment formulas. Accurately predictable cash flow streams with contractual rent increases are suitable for floating debt payments with provisions limiting minimum and maximum rate adjustments and accruals. Less calculable cash flow streams inclusive of new projects with leasing in progress require more structured accruals to match more fluctuating income collections.
Lenders include interim financing sources, particularly major credit companies, commercial banks, thrifts, insurance companies, and debt syndication funds.