Residual Insurance for Real Estate
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A new product for commercial real estate investors
Residual Value Insurance is a new product for commercial real estate investors. Although you may not have heard of this product, probably you or someone you know has been involved with a lease where residual value insurance has brought benefits to the transaction.
RVI is common in equipment and vehicle leasing. In an auto lease, the Lessor’s return is dependent upon the value of the auto at the end of the lease. When the vehicle is leased, residual value insurance is written indemnifying the Lessor from a drop in value of the auto at the end of the lease term. The policy has a one time fee and specifies that the vehicle must be properly maintained. Mileage limits are set.
The guarantee of value brings accounting benefits to both the lessor and lessee. The credit guarantee creates a bond for the lessor or manufacturer. The lessor can book the lease as a financing lease and income is declared at the beginning of the lease.
Since the lessee’s total payments are less than 90% of the value, the IRS allows the lessee to record the lease as an operating lease. As such, the lease payments can be tax deductible and the lease can be carried as a non balance sheet obligation.
The strong RVI market for vehicle leasing has allowed low depreciation vehicles to be leased for a fraction of the same vehicle’s monthly purchase payment bringing benefits to both the manufacturers and the lessees.
RVI for Real Estate:
RVI is now available for certain types of real estate transactions. A “credit” tenant must guarantee the income stream. Single tenant triple net leased properties are the most common coverage written. The time of coverage is date specific. The effective date of the policy is the last day of the initial term of the lease. If a mortgage is involved this date needs to coincide with the due date of the loan.
Underwriting:
Underwriting guidelines vary. Since the product is new, underwriters maintain they review each transaction separately. The insurer looks to the terms of the lease and the quality of the tenant to guarantee the maintenance of the improvements. The balance at the end of the mortgage term needs to be no greater than 35% of the current “appraised value” of the real estate. Appraised value is determined by market conditions and market rents.
Bonnie Barkely of RVI Inc, a company active in the RVI real estate market, stated, “Any evaluation has to pass the square footage test. We do not accept values with exorbitant square footage prices. We underwrite to market.” Ms. Barkley went on to say, “The entire department at RVI, Inc. is made up of real estate people, so we look at location and the flexibility of the improvements.”
The policy is generally written at time of loan origination. The premium is a one-time charge. Although premiums may vary 4% of the insured value is often used. The insured value is the loan balance at the end of the mortgage term. Premiums equates to about 1.35% of the purchase price of the property.
The RVI insurer is written into the mortgage documents as a successor and assign in the event of default. If the borrower cannot or elects not to pay the note when due, the insurance company is notified; the language detailing this notice is time specific. The insurer purchases the mortgage and proceeds with the foreclosure. As successor and assign the RVI insurer has all the rights and remedies of the original lender.
Benefits:
Loans with RVI have a more secure return to the lender and should demand lower interest rates and longer terms. Securitized lenders or Commercial Mortgage Backed Securities (CMBS) provide non-recourse, commercial real estate loans. The standard loan structure is a 10-year loan with a 30 year amortization. The loans are underwritten on asset value and cash flow. The greatest risk to the lender is loss of asset value and liquidity when the note is due. This risk is similar to the auto Lessor.
Because of the bond like guarantee that residual value insurance adds, CMBS lenders can sell the mortgages into more favorable risk traunches. The term of the mortgage can be extended to 15 or 20 years to coincide with the term of the lease. Equity requirements can be lowered. Some loans require as little as 3% down. Since leverage can be increased, the tax advantages of real estate can be extended and phantom income occur farther back in the amortization schedule.
Savings realized by favorable financing can be passed on to the tenant with a lower rent constant, or the owner can enjoy greater cash flow.
Policies can be written when no mortgage is involved. The property owner becomes the beneficiary. When RVI is combined with a NNN leased property to a credit tenant, the purchase becomes a corporate bond with depreciation and the transaction becomes an investment that’s minimum internal rate of return can be calculated.
Residual Value Insurance can be a solution to the 1031 challenge where a client has low equity but needs a lot of debt.
RVI can be incorporated into synthetic leases to provide accounting benefits for the lessor/financer/developer and the lessee/tenant. The benefits are like those described in the auto lease.
Application for the coverage is similar to the loan application. Coverage needs to be closely coordinated with the lender. Bonnie Barkley of the RVI Group says, “Some institutional lenders now require residual value insurance.”
Commercial Mortgage Backed Security lenders are in a unique position, once a CMBS loan is sold, it becomes a security and cannot be modified. Unlike the commercial banks, the CMBS lenders do not have the flexibility to renew or extend a loan. Therefore this additional layer of guarantee is very attractive to the CMBS lender.
Disadvantages:
Disadvantages of the product include cost of the premium and an additional layer of legal documents at time of loan origination. Since the coverage is date specific, a tenant default or bankruptcy during the term of the lease does not activate coverage. Like with all guarantees, you need to determine the credit of the insurer.
Like many insurance tools, RVI can bring benefits if you understand the purpose and the application.
