UNDERSTANDING COMMERCIAL REAL ESTATE FINANCE &

REAL ESTATE INVESTMENT TRUSTS (REIT)

Beth A. Di Santo, Esq.

Corporate Finance Partner

I. TRADITIONAL MORTGAGES

The following is a summary of the types of lenders by category:

The types of mortgages and related underwriting guidelines for residential and

commercial property are quite different. In its simplest terms, a mortgage is a method of

using real property as security for the repayment of debt. There are many variables to be

considered to determine the best financing product for your investment.

In general, there are three different types of loans on which banks lend:

-Construction: A construction loan is a temporary loan usually lasting six months to

a year that is used to complete a “to be built” project. Construction loans are paid off by a

long-term mortgage loan on the completed project. The proceeds from a construction

loan are disbursed in stages over the course of the project and the lender usually reviews

the project at various stages of the construction.

-Bridge: A bridge loan is a short-term loan that provides funds at the stage between

the construction phase and completion of the project (i.e., permanent financing stage).

Commercial bridge lenders may overlook property issues, incomplete permits, credit and

other problems in exchange for a higher rate of return. It is likely that lenders will look to

offset these risks by lending at a lower loan to value ratio, usually under 65% of the

property's value.

-Permanent: Permanent loans are generally loans with terms over three years. It is

common for lenders to convert construction loans to permanent loans upon completion of

construction. These loans are referred to as Construction-to-Permanent loans.

Commercial Mortgages and Real Estate Loans

Types of Commercial Property

The following is a breakdown of the various commercial property sectors. Each

sector faces its own set of issues that impact your ability to secure financing.

Multi-Family Garden Apartments

Hi-Rise Apartments

Mid-Rise Apartments

Low/Mod Income

Student Apartments

Senior Apartments

Underlying Coop

Retail Regional Enclosed

Strip Center

Outlet Mall

Free Standing

Single Tenant

Regional Unenclosed

Office Single Tenant

Hi-Rise Tower

Mid-Rise Office

Office Over Retail Heavy

Manufacturing

Light Manufacturing

Warehouse/Distribution

Owner Occupied

Multi-Tenant

Self Storage

Special Purpose

Health Care Congregate Living

Nursing Home

Rehabilitation

Ambulatory Care

Source: www.mortgage101.com

The Lender’s Perspective: Commercial Underwriting Guidelines

Underwriting standards and pricing of a loan is determined by the type of real

estate, tenancy, credit of the borrower and the institution or individual lending the funds.

In particular, the pricing is generally directly related to the risk associated with a

particular loan. Institutional lenders lend based on their cost of funds and access to

capital. When applying for a commercial loan, lenders typically evaluate certain criteria

to determine whether a particular loan will meet its underwriting guidelines. The

following is a brief summary of some of the most common underwriting guidelines:

Financial Analysis

The debt coverage ratio (“DCR”) is a crucial element to a lender’s evaluation of a

loan. The DCR is defined as the monthly debt compared to the net monthly income of the

property. Each lender has its own DCR policy and it’s important to understand what the

policy is before submitting an application. Most lenders will never go below a 1:1 ratio

(a dollar of debt payment per dollar of income generated) because anything less then a

1:1 ratio will result in a negative cash flow situation.

Loan to Value

Lenders typically view commercial investment properties more conservatively.

Lenders also look at the loan to value (“LTV”) ratio in evaluating an application. The

LTV is the percentage calculation of the loan amount divided by purchase price. It is

common for commercial lenders to require a larger upfront commitment from buyers

(i.e., a minimum cash payment of 20% by buyers). In commercial transactions, it is

imperative that the appraisal reflect the highest valuation for the property. This will

enable the buyer to receive more loan proceeds based on the LTV calculation.

Credit Worthiness

In general, commercial loans are held in the name of the business owning and/or

investing in the commercial property. If the business is less than three years old, it is

likely that the lender will require a personal guaranty from the principals of the company.

Further, lenders will rely on the credit history of the principals in evaluating a prospective

loan.

Property Analysis

In many instances, a commercial lender will conduct a fairly thorough analysis of

the fair market value of the subject property. Lenders will also analyze other

characteristics that may impact the value of a property (i.e., age, appearance, local

market, location, and accessibility).

Funding Needs Capital Source

-Acquisition and Development: Raw land infrastructure development (streets,

utilities, etc.)

-Adjustable Commercial Mortgage: Interest moves with a specific index (Prime, T-

Bills, etc.)

-Construction Mini-Perm: Construction with 3 to 5 year loan, usually on

income property.

-Construction Loan with Take-out: Construction with pre-arranged takeout loan in

place.

-Fixed Rate Commercial Mortgage: Interest Rate remains constant throughout the

term.

-Hard Money Loan: Loans from private lenders based primarily on

the hard asset value (commercial building,

vacant land, etc.).

-Interim Loan: A short term (2 yrs or less), bridge or project

type loan.

-Joint Venture: A financial partner in the development of real

estate.

-Participating Mortgage: Lender receives a kicker for gross income above

a preset level.

-Real Estate Sale and Leaseback: Lender purchases land and leases back to

borrower (generally developer) for a fixed rent

plus other considerations. Mortgages are issued

on leasehold at market rates. Usually, produces

more dollars than a mortgage.

-Real Estate Purchase Loan: Lending for the purchase of commercial real

estate.

-Second Mortgage(Commercial): Loan secured by equity behind that of the first

lien.

-Wraparound: Lender makes a second mortgage and assumes

the first mortgage.

The Borrower’s Perspective: Closing Commercial Loans

Commercial loans present a variety of legal and business issues that both borrowers

and their attorneys needs to recognize and negotiate. It is important for attorneys to

determine the legal issues that are important to their clients and the timeframe within

which the loan needs to close. Borrowers are mostly concerned with their liability under

the documents and the restrictions contained therein that relate to borrower’s ability to

operate their business. The following discussion addresses some of the more common

issues presented by commercial loans.

Prepayment Provisions

It is common for commercial loans (especially fixed rate loans) to include a

prepayment provision that limits a borrower’s ability to prepay all or part of the loan

prior to a date certain. . A prepayment penalty is a fee that is paid to the lender to

compensate it for the lost income it would have earned if the loan was not repaid prior to

the maturity date. It is imperative to address the prepayment terms so that the borrower

will have the flexibility to prepay the loan. Borrowers may with to prepay the loan if

they are able to refinance at lower interest rates or sell the property. The prepayment

provision should not be applicable in the event of certain involuntary prepayments (i.e.,

prepayment due to application of casualty process or condemnation).

Recourse

A recourse loan is a loan where the lender can look to both the collateral securing

the loan (i.e., the property) and the borrower in the event of default. A non-recourse loan

means that a lender can only look to the collateral to satisfy the loan obligations in the

event of default. It is common for a non-recourse loan to have a “bad-boy” provision that

allows the lender to look to the borrower if the borrower engages in certain bad acts.

These “bad-boy” provisions are essential carve-outs from the non-recourse aspects of a

loan that allow the lender to go after the borrower in the event of intentional acts by its

borrower. These certain circumstances include: environmental contamination,

misappropriation of funds, fraudulent misrepresentation, waste, and other types of serious

defaults. The loan documents should clearly limit liability to the appropriate parties. For

example, if the borrower is a partnership, the lender’s recourse should be limited to the

assets of the partnership and exclude recourse against the members of the partnership.

Further, the recourse provisions should be limited to actual damages incurred by a lender

rather than converting the loan to full recourse in the event of a violation.

In addition to the “bad-boy” provision, a bankruptcy or similar attempt to limit

lender’s ability to enforce/foreclose the lien against the property may also give the lender

recourse against the borrower.

Remedy and Default Provisions

The remedy provisions of the loan documents should be reviewed carefully to

ensure that the lender is not entitled to any extraordinary or inappropriate remedies. It is

difficult to negotiate remedies since these provisions are only effective in the event of a

borrower default. However, you can negotiate for appropriate grace periods and/or cure

periods to limit the events of default. Further, the events triggering a default should also

be negotiated to exclude circumstances outside the borrower’s control. For example, loss

of rental income due to tenant’s financial difficulties could cause a default on the debt

service coverage ratio. It may be possible to negotiate for a provision that would allow

the borrower to reduce the principal of the loan to remedy any debt service coverage ratio

defaults due to such loss of income.

Environmental Matters

Liability for environmental matters can be a major concern with commercial

properties, especially with respect to certain types of property. It is common for loan

documents to contain expansive representations, warranties and covenants from the

borrower regarding environmental matters. These provisions need to be carefully

reviewed and negotiated to limit borrower’s exposure. For example, the provisions

should exclude matters contained in existing environmental reports and include only

matters within the borrower’s actual knowledge. It is critical for the borrower and its

advisors to conduct a thorough due diligence investigation of a property to uncover any

potentially harmful conditions. The borrower’s representations should provide a basis for

liability only for matters that the borrower willfully withholds or omits.

Environmental indemnification provisions also need to be negotiated and limited

in time and scope. First, the loan documents should provide that the borrower’s liability

for environmental matters ceases upon a sale or transfer of the property. The lender may

seek to extend such liability after the borrower sells or refinances the property. It is

common for loan documents to provide an indemnification period through the statute of

limitations for the relevant environmental matter. Borrower’s should seek to have the

indemnification period limited to a date certain after closing because the statute of

limitations for certain environmental matters does not begin to toll until discovery of an

environmental condition.

Assignment of Leases

Lenders often seek to exercise control over the borrower’s lease arrangement with

its tenants because it is a major source of income that is used to repay the debt.

Borrower’s, however, need to maintain a certain level of control over its leasing

arrangements in order to effectively operate its business and maximize income. As such,

the borrower should attempt to limit the lenders control over its rental income and leasing

arrangements. It may be possible to create a “Form of Lease Agreement” that is

reviewed and approved by the lender at the loan closing that can be used for future

tenants. In the event that the lender does maintain some control over leasing decisions,

the loan documents should provide very clear terms and conditions and time limits for the

lender’s involvement.

Transfers

The loan documents will provide for restrictions on transfers of the property

and/or transfers of interests in the borrowing entity. The borrower should seek the

flexibility to transfer the property under certain limited circumstances. Further, the

ability to add or remove members or partners from the borrowing entity should also be

retained given that the borrower’s circumstances post-closing may change. It is likely

that the lender will require the managing member or general partner to remain obligated

under the loan documents. Transfer restrictions may be drafted so broadly as to include

put/call rights or rights of first offer that may be included in the operating agreements of

the borrower. If your investment is structured to include those sorts of rights, the transfer

provisions should be modified to specifically exclude those circumstances.

Borrower Entities

Lenders will often require that a borrower be formed as a single asset entity,

special purpose entity and securitized loans. This requirement is generally imposed to

limit the lender’s exposure to bankruptcy and default by isolating the collateral owned by

the borrower. If the entity is formed properly, affiliate entities of the borrower that

experience financial difficulties will not affect the subject property. The main

implication of these provisions for the borrower is the additional transaction cost of

forming and maintaining the new entity (for a purchase) or transferring the property (for a

refinance).

Lenders involved in securitized loans will require that the borrowing entity be a

“bankruptcy remote.” The loan documents will include several covenants that relate to

the maintenance of such an entity. Some of the common requirements are as follows:

Maintain the borrower’s assets in a way which segregates and identifies such

assets separate and apart from the assets of any other person or entity;

Hold itself out to the public as a separate legal entity distinct from any other

person or entity;

Conduct business solely in its own name;

Have no indebtedness other than a loan being made secured by a particular

property and indebtedness for trade payables incurred in the ordinary course of

business; and

Have “independent directors” that must vote on matters involving the dissolution

or bankruptcy of the borrower and certain amendments to the borrower’s

organizational documents.

II. SECURITIZATION OF DEBT

What is Securitization of Debt?

Securitization of debt is a process by which identified pools of receivables, which are

usually

illiquid on their own, are transformed into marketable securities through suitable

repackaging of cash flows that such receivables generate. Essentially, securitization is a

credit arbitrage transaction that permits for more efficient management of risks by

isolating a specific pool of assets from the originator's balance sheet. Securitization is a

method of obtaining investment capital by selling interests in a pool of financial assets

(such as mortgage loans) to investors in the capital markets. The lenders are able to

diversity their investment and spread their risk of loss by pooling their funds and

investments together.

A traditional lender lends money to borrowers from its own balance sheet. With

securitization, the lender raises money in the capital markets to lend to borrowers. After

a loan is originated, the loan is pooled together with other loans, transfers it to an arranger

who then sells the income from such pool to investors in the form of securities in the

capital markets.

Parties to a Securitization

The following is an overview of the parties involved in a typical securitization:

-Originator—Owner and “generator” of the assets to be securitized (i.e., banks and other

financial institutions, governments and municipalities).

-Seller—Seller of the assets to be securitized.

-Purchaser/Issuer—A special purpose entity (SPE) that purchases the assets to be

securitized and funds the purchase price by issuing asset-backed securities into the capital

markets.

-Servicer—services the assets to be securitized and is responsible for collection,

administration and, if necessary, enforcement of the receivables;

-Investors—Purchasers of the asset-backed securities in the capital markets (i.e., pension

funds, banks, mutual funds, hedge funds, insurance companies, etc.).

-Lead Manager—Arranger of the transaction who is often the primary distributor of the

asset-backed securities in a particular transaction.

-Rating Agencies—Rate the asset-backed securities that are issued. The three key rating

agencies for securitizations are Standard & Poor’s, Moody’s and Fitch.

-Hedge Providers—Hedge any currency or interest rate exposures the Purchaser/Issuer

may have as a result of the securitization.

-Cash Administrator—Provides banking and cash administration services to the Issuer.

-Security Trustee—Acts as a trustee for the secured creditors of the Purchaser/Issuer.

-Note Trustee—Acts on behalf of the holders of the asset-backed securities.

-Auditors—if necessary they audit the asset pool as may be required under the

documentation of the relevant transaction.

Benefits of Securitization

The Lender/Originator’s Perspective

There are several reasons why lenders engage in securitized lending and the sale

of asset-backed securities:

-Access to Funds—Originators are able to raise funding in the form of the purchase price

to be paid by the SPE upon the sale and transfer of the securitized assets.

-Credit Exposure—Following securitization, the Originator’s credit exposure will be

limited to any credit enhancement it may provide.

-Improved Balance Sheet—A true sale securitization improves the Originator’s balance

sheet ratios to the extent that proceeds of the securitization are used to repay existing

liabilities, which may reduce the Originator’s leverage.

-Access to Funding Sources—Securitization allows the Originator to diversify its

funding sources away from banks in favor of the capital markets, without

having to issue securities on its own. Originators who already have established

direct access to the capital markets.

-Reduced funding costs. The weighted average cost of the securitization may be lower

than the cost of the Originator’s current bank or other debt. Notably, this is often the

case if the credit quality of the securitized assets is higher than the credit quality of

the Originator’s balance sheet as a whole.

The Investor’s Perspective

Investors in asset-backed securities can benefit in a number of ways, including the

following:

-Portfolio Optimization—Asset-backed securities provide a means for investors to invest

in asset classes and risk tranches of their choice and generate the associated returns.

-Reduced Volatility. Asset-backed securities have historically often been less volatile as

compared to corporate bonds.

-Favorable Yield Premium—Asset-backed securities have been known to offer a yield

premium over comparably rated government, bank and corporate bonds.

-Risk Diversification—Asset-backed securities are usually not susceptible to event risk or

the risk of a rating downgrade of a single borrower.

Issues with Securitized Loans

The purpose of a securitization transaction is to separate the borrower’s credit risk

from the leveraged asset. As a result, securitizing lenders deal with credit risk differently

than traditional lenders by structuring the loan and the borrowing entity in a way that

segregates the leveraged asset and requires higher impounds and reserves at closing. The

main issues with securitized loans are summarized below.

Credit Risk

In order to reduce credit risk, securitized lenders require that borrowers place the

collateral property in a special purpose vehicle (or SPV) thereby removing it from the

borrower’s balance sheet. The SPV is the borrower under the loan documents and is the

subject of several restrictive operational covenants. These requirements are intended to

isolate the property from other creditors and give the lender additional control of the

property after a default. In general, the rating agencies will ignore the credit risks related

to the borrower and look only the asset and immediate liabilities related to the property

itself. As a result, securitized loan documents focus more closely on property cash flow

and require stricter covenants on late rents and tenant vacancies and debt-service

coverage ratios. A traditional lender is generally more focused on borrower’s financial

status and loan-to-appraised value ratios.

Another method to reduce credit risk involves the use of impounds and reserves.

Rather than relying solely on borrower covenants, the securitized lender will require pre-

payments at closing of post-closing liabilities that could impact the collateral. SPV

borrowers will be required to fund reserve accounts for taxes, insurance and maintenance.

Lenders may also require additional insurance that would cover business interruption.

Credit Enhancement

A traditional lender may require credit enhancements if it determines that a

proposed loan has a high credit risk. Credit enhancements can take the form of additional

collateral, guarantees from creditworthy third parties, or cash reserves. On the other

hand, securitized lenders generally seek credit enhancements from the assets of the SPV

itself and cash reserves at closing. Third party credit enhancements are generally avoided

because this arrangement would require additional disclosure by the arranger in the

investor documents because the loan would not be in accordance with its uniform

standards. Additionally, rating agencies may lower their ratings which decrease the price

that investors are willing to pay for the asset-backed securities. However, several

originators and arrangers allow certain risks to be covered by a third party guaranty, such

as “bad boy” acts and environmental risks.

Restrictions on Junior Debt

Securitized lenders generally prohibit borrowers from incurring any junior debt.

In generally, the loan documents only permit the SPV borrower to incur the senior

securitized debt, liabilities to existing tenants under leases and trade debt incurred in the

ordinary course of business. These restrictions must be carefully considered while

negotiating the loan package.

Bankruptcy Remote Structures

Securitized lenders require that borrowers form an SPV to reduce the likelihood

that the borrower will become subject to a bankruptcy proceeding. In addition, lenders

generally require that a borrower adopt special charter and covenant provisions intended

to impair the borrower’s ability to file bankruptcy. This is called a “bankruptcy remote”

structure. BRVs also make certain covenants that are designed to maintain its corporate

identity separate from its parent, which reduces the risk that the BRV will be pulled into

the parent’s balance sheet in the parent’s bankruptcy proceeding. Lenders will also

require additional legal protection that is designed to assure the original contribution of

the property to the BRV was valid and not a fraudulent transfer.

Insurance Proceeds

All lenders require that borrowers maintain insurance coverage against the risks

of loss, usually with the lender listed as an additional insured in the loss payee clause of

such policy. The objectives of a securitized lender is different than that of a traditional

lender because they are interested in uninterrupted cash flow so that they can make

payments on the securities over a period of time. As a result, securitized lenders may

include a requirement that the insurance proceeds from a casualty be used to rebuild the

property rather than applying such proceeds to repay such loan.

Prepayment Provisions

Traditional lenders may permit prepayment of a loan without penalty, but this is

usually figured into the loan pricing. Some lenders will restrict a borrower’s ability to

prepay by limiting the time period, amount of prepayment and application of certain

prepayment fees. On the contrary, prepayments of securitized loans are always penalized

by a fee which may be characterized as a “yield maintenance fee,” “breakage fee” or

similar defeasance provision. The terms of the loan documents will penalize or mitigate

prepayments to assure predictability of repayment. The objective of these fees is to

compensate the lender for the “time-value-of money” as if the loan would have remained

outstanding until the scheduled maturity date. A defeasance provision is where the

original collateral is replaced by reliable financial instruments (such as Treasury

securities) that compensate the lender in the same way as the remaining debt service.

Defeasance is a method to maintain the original payment stream despite the fact that the

original asset has been removed.

Transfer Rights

Transfers of securitized loans are the norm. The objective of securitization is for

a lender to transfer a loan off of its balance sheet and into a securitized loan pool owned

by investors. In traditional loans, borrowers may seek to restrict the lenders right to

transfer a loan to maintain continuity of the business relationship with the lender. This is

not a realistic option with securitized lenders. Mortgage-backed securities are relatively

easy for an investor to evaluate as a result of the use of rating agencies, standardized loan

packages and summary disclosure documents.

Standardized Loan Packages

In packaging loans for securitization, arrangers require originators to use

standardized loan packages that have been developed for model disclosure and risk

analysis. The use of the standardized loan packages is critical to the reduction of

administrative costs that would otherwise be involved in evaluating unique loan

packages.

Pre-Pooling Analysis

Before loans are placed in a securitization pool, the loan packages are reviewed

for completeness and conformity to the pooling requirements. If there are deviations

from the pool requirements, a loan may be rejected by the arranger. A non-standardized

loan will not be acceptable because it renders the arranger’s uniform disclosure to

investors untrue with respect to that loan.

III. REAL ESTATE INVESTMENT TRUSTS

A real estate investment trust (or REIT) is a business entity that invests in real estate

directly, either through properties or mortgages. REITs are financial vehicles that allow

investors to pool funds for participation in real estate ownership or financing. Since

2001, REITs have been included in the Standard & Poor’s 500 Stock Index, the most

widely followed investment performance benchmark for U.S. equity markets. This

addition is evidence of the importance of commercial real estate in public capital markets.

REITs over time have demonstrated a historical track record providing a high level of

current income combined with long-term share price appreciation, inflation protection,

and prudent diversification for investors across the age and investment style spectrums.1

To qualify as a REIT, a company must distribute at least 90% of its taxable income to

its shareholders annually. A company that qualifies as a REIT is permitted to deduct

dividends paid to its shareholders from its corporate taxable income. As a result, most

REITs remit at least 100% of their taxable income to their shareholders and therefore owe

no corporate tax. Taxes are paid by shareholders on the dividends received and any

1 Investors Guide to Real Estate Investment Trusts, National Association of Real Estate Investment Trust.

capital gains. Most states honor this federal treatment and also do not require REITs to

pay state income tax. Like other businesses, but unlike partnerships, a REIT cannot pass

any tax losses through to its investors. REITs receive special tax considerations, and

typically offer investors high yields as well as a highly liquid method of investing in real

estate. There are three basis types of REITs:

Equity REITs: Equity REITS invest in and own properties (thus responsible for

the equity or value of their real estate assets). Their revenues come principally

from their properties' rents.

Mortgage REITs: Mortgage REITs deal in investment and ownership of property

mortgages. These REITs loan money for mortgages to owners of real estate, or

invest in (purchase) existing mortgages or mortgage backed securities. Their

revenues are generated primarily by the interest that they earn on the mortgage

loans.

Hybrid REITs: Hybrid REITs combine the investment strategies of Equity REITs

and Mortgage REITs by investing in both properties and mortgages.

Dividends and Diversification

As discussed further below, REITs must pay out almost all of their taxable income to

shareholders. REITs can provide investors reliable and significant dividends (four times

higher than those of other stocks, on average). Analysis of historical data concluded that

the relatively low correlation between REITs and other stocks and bonds makes them a

powerful diversification tool.

Forming & Qualifying as a REIT

The following generally summarizes some of the basic tax law requirements applicable to

REITs. These rules are complex, and the following is only a general summary. In order to

qualify as a REIT, an entity must meet a number of organizational, operational,

distribution, and compliance requirements.

Organizational Requirements

A REIT must be formed in as an entity taxable for federal purposes as a corporation. It

must be governed by a board of directors or trustees, and its shares must be transferable.

Beginning with its second taxable year, a REIT must meet two ownership tests: it must

have at least 100 different shareholders (or the 100 Shareholder Test), and 5 or fewer

individuals cannot own more than 50% of the value of the REIT's stock during the last

half of its taxable year (or the 5/50 Test). These ownership requirements generally mean

that the REIT structure is not a good choice for a closely held family business. A number

of "look through" rules currently apply when determining whether the REIT meets the

5/50 Test.

In an attempt to ensure compliance with these tests, most REITs include percentage

ownership limitations in their organizational documents. For example, many REITs do

not permit any one shareholder to own more than at most 9.8% of a REIT's stock without

a waiver by the REIT's board of directors. Because of the need to have 100 shareholders

and the complexity of both of these tests, general legal, and tax and securities law advice

are strongly recommended prior to beginning the process of forming a REIT.

Operational Requirements

The REIT must satisfy two annual income tests and a number of quarterly asset tests that

are designed to ensure that the majority of the REIT's income and assets are derived from

real estate sources.

Annually, at least 75% of the REIT's gross income must be from real

estate-related income such as rents from real property and interest on

obligations secured by mortgages on real property. Additionally, 95% of

the REIT's gross income must be from the above-listed sources, but can

also include other passive forms of income such as dividends and interest

from non-real estate sources (like bank deposit interest). As a result of

these rules, no more than 5% of a REIT's income can be from

nonqualifying sources, such as from service fees or a non-real estate

business. A REIT can own up to 100% of the stock of a "taxable REIT

subsidiary" ("TRS"), a corporation with which a REIT makes a joint

election that can earn such income.

Quarterly, at least 75% of a REIT's assets must consist of real estate assets

such as real property or loans secured by real property. Although a REIT

can own up to 100% of a TRS, a REIT cannot own, directly or indirectly,

more than 10% of the voting securities of any corporation other than

another REIT, TRS or qualified REIT subsidiary ("QRS"), a wholly-

owned subsidiary of the REIT whose assets and income are considered

owned by the REIT for tax purposes. Nor can a REIT own stock in a

corporation (other than a REIT, TRS or QRS) the value of whose stock

comprises more than 5% of a REIT's assets. Finally, the value of the stock

of all of a REIT's TRSs cannot comprise more than 20% of the value of

the REIT's assets.

Distribution Requirements

In order to qualify as a REIT, generally, the REIT must distribute at least 90% of the

sum of its taxable income. To the extent that the REIT retains income, it must pay tax on

such income just like any other corporation.

Compliance Requirements

In order to qualify as a REIT, a company must make a REIT election. The REIT

election is made by filing an income tax return on Form 1120-REIT. Because this form is

not due until, at the earliest, March 15th following the end of the REIT's last tax year, the

REIT does not make its election until after the end of its first year (or part-year) as a

REIT. Nevertheless, if it desires to qualify as a REIT for that year, it must meet the

various REIT tests during that year (with the exception of the 100 Shareholder Test and

the 5/50 Test, both of which must be met beginning with the REIT's second taxable year.)

Additionally, the REIT annually must mail letters to its shareholders of record requesting

details of beneficial ownership of shares. Significant monetary penalties will apply to a

REIT that fails to mail these letters on a timely basis.

Advantages of REITs

Investing in real estate assets through the purchase of REIT shares provides certain

advantages not offer by alternative investments, including:

-Double taxation of distributions is avoided, thereby allowing more of the investor's

capital to compound.

-An experienced management team is responsible for the day-to-day operation of the

business, providing the investor with real estate industry expertise.

-Unlike real estate directly held by the investor, REITs are a liquid asset that can be

sold fairly quickly to raise cash or take advantage of other investment opportunities.

-Investors with are able to diversify their holdings between various geographic areas

and property specializations, which would not be financial feasible for most investors

through direct ownership of property.

-REITs have access to debt and equity markets to raise funds to take advantage of

opportunities when they arise.

-REITs have a lower correlation to equities than many other asset classes, providing

portfolio stability for those with an active asset allocation strategy.

-High cash dividends relative to the market tend to establish phantom bottoms to

REIT share prices, often keeping them from falling as far as common stock in bear

markets.

IV. CONSTRUCTION FINANCING

Construction financing is used to cover the variety of costs and expenses that are

incurred during the course of a construction project, including without limitation the

following:

Soft costs: Architectural, engineering, survey, construction permits, local taxes, utility

connection fees, and in general all the fees associated with the things that are done on

paper before the actual construction starts.

Hard costs: Actual cost of construction incurred from the moment the digging begins

all the way to laying the floor coverings and putting the landscaping and hardscaping

in.

Closing costs: All costs associated with closing the construction loan, including

origination fees, lender fees, title insurance, escrow or attorney fees, property

insurance, course of construction insurance, recording, funding and closing fees.

Land/Lot Value: The value of the land/lot to be built on or the structure that is being

improved. To determine the current land/lot value: (i) if the property is owned for

more than a year the fair market value is used or (ii) the purchase price is used if

owned for less than a year. If there is an existing property that will need to be

demolished, then the land/lot value may be the current fair market value of the total

property or the empty lot depending on the particular program’s guidelines.

Interest reserve: The interest reserve is determined by calculating 60 or 70% of the

simple interest on the total construction loan amount. This reserve will be used to

make the payments on the construction loan during construction. Interest is calculated

based on the actual amount borrowed at any one time and charged against the interest

reserve during construction.

Contingency reserve: A contingence reserve is always built into the budget to ensure

the timely completion of the project despite unforeseen price increases or cost over

runs. Contingency reserve is normally calculated at 5% of the total cost of

construction.

Inspection fees: Construction loans are reimbursement loans and as such, funds are

disbursed based on the work completed as verified by an inspector.

There are several ways to obtain financing for construction. Some of the more

common methods used by commercial developers are:

-Equity Financing—An investor provides funds for the construction in return for

equity in the business entity that is operating as the developer.

-Joint Ventures—An existing developer may enter into an agreement with a third

party individual or company to provide funds in exchange for a participation fee in the

profits realized from the construction project.

-Traditional Financing—A lender provides a loan for the construction (which is the

most common method and is discussed in detail below).

Types of Construction Loans

Constructions loans are generally structured to be temporary in nature and replaced

by permanent financing upon completion of the building project. There are two basic

types of construction loans:

-Construction-to-permanent loan: Generally, the borrower will only pay the loan

interest during the construction phase. After completion of the project, the loan converts

to a traditional mortgage where the borrower begins paying principal and interest. One of

the main advantages of this type of loan is that there is one loan application and one

closing. As such, borrowers are able to reduce the underwriting and closings costs

associated with two separate loans (i.e., mortgage taxes, title insurance fees, and other

closing costs). One disadvantage is that borrowers are not free to shop around for better

permanent financing at the completion of the project.

-Construction-only loan: This structure requires a separate loan for construction

purposes and a mortgage upon completion of the project. Only the interest is paid during

the term of the construction loan (usually short term) with the principal becoming due

when construction is complete. There are generally more closing costs with these types

of loans because there are two closings. However, borrowers are free to shop around for

permanent financing during the construction phase which may be advantageous

depending on market conditions.

Steps to Obtain a Construction Loan

Collateral: Many lenders will require the borrower to own the land before they can apply

for a construction loan. The lender will use the underlying land as its collateral for the

loan. Some lenders, however, will allow borrower to roll-up the land acquisition with the

construction financing.

Timing: Construction loans are generally short term loans with interest only payments

during the term and the principal becoming due at the end of the term.

Budgeting: It is critical to create an accurate budget for the entire project before applying

for the loan. As such, the borrower must obtain and evaluate any third party quotes

before creating the project budget. Lenders are averse to increasing amounts borrowed

after the construction has commenced.

Draws: Disbursements of the loan proceeds are called “draws.” The borrower will seek

to correspond the timing of the draws with payments of anticipated expenses in the

budget.

V. CONVERTIBLE DEBT

In addition to debt financing (i.e., mortgages) and equity financings (i.e., private

placements of securities), convertible debt is another financing alternative available to

real estate owners and investors. Convertible Debt is a loan (debt obligation) that can

convert to equity (stock ownership) under certain circumstances usually at some pre-

announced ratio. Convertible debt can take the form of corporate bonds, convertible

preferred stock, or mandatory convertible securities. Investors tend to like convertible

debt because they are in a “win-win situation”: if the borrower does well the investors

shares in the upside of the equity and if the borrower does poorly the investor is still

entitled to repayment of the debt obligation.

Although it typically has a low interest rate, the holder is compensated with the

ability to convert the debt to common stock, usually at a substantial premium to the

stock's market value. From the issuer's perspective, the key benefit of raising funds by

issuing convertible debt is a reduced cash interest payment. The primary disadvantage,

however, is that the value of shareholder's equity is reduced due to the dilution expected

when holders convert their debt into equity.

Raising Funds Using Convertible Debt

Convertible debt offerings are essentially securities offerings that can be made

publicly for listed companies or through private placements. It is critical to consult with

a securities law attorney before offering or issuing any convertible debt to ensure that you

are in compliance with all applicable federal and state securities laws. Issuers will need

fairly detailed disclosure documents (i.e., private placement memorandums, subscription

agreements, notes evidencing the debt and call provisions, etc.).