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Real Estate Capital Basics – Standby Commitments

RECI, 01 July 1990, No comments
Categories: Uncategorized

  

Standby Commitments are temporary financing tools required for obtaining construction loans on speculative, to-be-built, or major renovation projects.  Based on a predefined set of terms and conditions, the standby issuer [lender] provides a commitment to finance a to-be-built project at a future date.  Relying on this commitment as a takeout funding, a construction lender provides the necessary funds to complete the project.  Simultaneously, the borrower is certain that financing is available when the project is completed.

Regular, Presale and Suicide are three forms of standby commitments found in the marketplace today.

Regular Standby

With a Regular Standby, the issue or is prepared to take out the construction loan upon project completion, providing the borrower with a mini-perm (short term) first mortgage.  The mini-perm debt is usually underwritten as a fixed- or floating-rate, accrual loan.   Real estate investment banks, credit companies and other entrepreneurial financial institutions are popular sources for this rare type of financing. Regular Standbys are highly suitable for financing extremely challenging properties including lodging, healthcare and highly speculative developments.

Presales Standby

A Presales Standby is essentially a pre-purchase agreement, allowing the issuer to purchase the property upon completion at a predetermined price.  The purchase price is discounted to allow for the time value of risk, and at a minimum, cover the construction costs.  Life insurance companies, pension funds and other institutional equity investors provide this type of funding mechanism in an effort to acquire difficult-to-purchase properties.   Borrowers are actually merchant builders in these situations, resorting to Presales Standbys as alternatives to other maximum-leverage funding vehicles (e.g. joint ventures). 

Suicide Standby

As the name implies, a Suicide Standby is a funding structure of last resort.  The standby issuer offers a commitment with extremely arduous terms and conditions, effectively discouraging the borrower from funding the loan.  For instance, a loan term of 400 basis points over Bank Prime plus a 5% fee reflects very unfavorable take-out funding terms.  The Issuer earns hefty upfront fees as well as highly punitive profits upon construction completion.  The borrower uses the Suicide Standby to develop or renovate extremely challenging properties, hoping that more favorable permanent financing and/or market sale conditions will be available upon project completion, eliminating the necessity of funding the Suicide Standby.  Funding requirements for Suicide Standbys are similar to other Standby vehicles.

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Chicago, Illinois, August 2, 2010 – Mid-year key economic indicators point to a more moderate recovery.  During July, benchmark treasuries moved within a quarter point range and settled lower by about 20 basis points for five-year notes, while ten-year notes moved down less than 10 basis points, respectively.  Mortgage spreads continued to barely tighten, netting slightly lower overall rates. Throughout the first half of the year, lenders have been scouring the realty markets in search of performing projects with stabilized cash flow.  Yet limited opportunities may be found.  Simultaneously, scant funding options are available for projects without cash flow performance.   Few capital sources reach for deals on longer-term cash flow projects, unless substantial equity exists.  With mortgage rates starting in the mid-4% range for longer term debt of seven years or greater, borrowers are migrating from floating-rate to fixed-rate debt.  As rates are at historical lows, focus on loan terms - other than pricing - include the following:  Loan-to-value sizing dominates underwriting funding limits, as debt service coverage ratios are relatively high due to low rates Subordination and non-disturbance agreements are more important to lenders as various players in the capital stack (e.g., mezzanine and preferred equity) take on new positions in situations where developer equity is reduced or eliminated Real estate tax and insurance collection conditions are more stringent, with lenders seeking tighter control in case of default Property insurance carriers must meet higher standards due to default within the industry Unauthorized transfers are no longer covered by most title policies, adding additional recourse carveouts Skip Perry, Real Estate Capital Institute advisory board member notes that "lenders want quality loans, and are willing to sacrifice yield in return for safety of principal."  He suggests, "conservatively underwritten income-property loans are precious commodities capturing premium pricing and terms.”