S.E.C. Real Estate Observer

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*Excerpted from Creative Down Payments, a book by Chuck Sutherland

Strategy

As an incentive for a financial institution to make a loan, you can entice a third party to place compensating balances into the bank. Those compensating balances might be in the form of checking accounts, savings accounts, or Certificates of Deposit.

Dick Janson, a member of the Society of Exchange Counselors (SEC) in of Austin, Texas, had a national, credit-rated tenant who wanted a building built and leased to them under a Net-Net-Net” lease. A Net-Net-Net lease (sometimes described as a NNN lease) is one with all of the operating expenses paid by the tenant. These operating expenses include such items as property taxes, insurance and, maintenance.

This type of “Net-Net-Net” lease is in strong demand by potential Buyers. However, most of the typical buyers for this type of property want a completed building with a paying tenant occupying the building. The problem was that, while there would be buyers for the NNN leased property once the building was built and the lease started, Dick did not have the cash—about $700,000—to develop the property and build the building.

Normally, financing a Net-Net-Net leased building with a national tenant would be easy. However, the real estate development market in Austin was in a slump that mirrored a national economic slowdown. Banks already owned many commercial loans that were in default or in danger of going into default. Even on completed buildings, loans were not easy to obtain.

Furthermore, banks in the area were not interested in making a construction loan to build the building. There is more risk during the construction phase than at any other time during the total ownership period. That is because so many things can disrupt the construction schedule and budget. Bad weather, material shortages, builder fraud, labor strikes, changes in local politics, and an endless list of other potential problems all make a construction loan less desirable to a bank that a loan on a finished product.

One bank said they would normally have an interest, but a development loan at that time just represented too much risk for them.

Solution

Dick asked the bank loan officer if they would make the loan if he could arrange a sizeable deposit into the bank. The loan officer agreed to consider that idea.

Dick asked an investor to put up $300,000 for a one-year Certificate of Deposit in the bank. Dick promised that the Certificate of Deposit would not be pledged to the bank for the loan in any way. The investor would receive a small amount of monthly interest from the bank as long as the money was invested in the Certificate of Deposit. As additional consideration for the investor purchasing the Certificate of Deposit at the bank, Dick’s company also paid an additional return to the investor.

With this structure, the bank made the $700,000 construction loan. Even though the $300,000 Certificate of Deposit was not pledged as security for the loan, the money going into the lending bank reduced the risk of the loan in the banker’s mind. In this case, safety was a matter of perception, not just some objective standard.

The Bank received 7 percent on the total $700,000 construction loan and paid out .5 percent on the $300,000 Certificate of Deposit. For the one-year term of the loan, they made a net interest profit of $47,500 with no additional net investment for that portion of the construction loan (see below). That $47,500 net interest profit represented an 11.88 percent yield on the net $400,000 loan by the bank. The calculation of the net yield to the bank is shown on the following chart:

That 11.88 percent yield to the Bank on net cash invested by the Bank is substantially higher than the yield the bank would receive on a normal loan. It must be remembered, however, that the $300,000 invested in the Certificate of Deposit is not pledged for the $700,000 construction loan. The construction loans stands on this own in the event of any default by the Buyer / Developer.

Dick Janson built the building and the national tenant moved in under the long-term Net-Net-Net lease. Once the building was completed, Dick sold it for a good profit for himself and the investor.

Summary of Transaction

Step 1: Buyer (Developer) writes contract to purchase land for development

Buyer (Developer) → Writes contract offering to purchase land
Buyer (Developer)→ Includes contingency of obtaining financing to build a building on the site

Step 2: Buyer (Developer) negotiates the lease with credit-rated tenant

Buyer (Developer)→ Includes contingency in lease of obtaining financing for the proposed development

Step 3: Buyer (Developer)→ Finances the purchase of land and building costs

Investor → Deposits $300,000 into a Certificate of Deposit into the a Bank
Bank → Makes a $700,000 construction loan to the Buyer / Developer
Buyer (Developer)→ Invests $0 cash in the land and building

Step 2: Buy land, build building, and sell

Buyer (Developer) → Buys the land and builds the building
Tenant → Moves into the building and starts paying on the Net-Net-Net lease
Buyer (Developer)→ Receives monthly income from the Net-Net-Net lease
Buyer (Developer)→ Sells the completed building for a profit

Benefits

Benefit to Developer (Dick Janson):

The Developer was able to build the building because he received the money from the loan.  The Bank made the loan partially because of the deposit of $300,000 for the Certificate of Deposit. The Developer received a 100 percent loan to cost. This is not typically available from a bank, even with a Net-Net-Net leased building with a national tenant.

The Developer made a profit from the lease income and from the sale of the leased building.

Benefit to the Investor:

The Investor received an excellent return from the combination of the Certificate of Deposit interest and the percentage of profits payments by the developer.

The Investor never risked any portion of the $300,000 invested in the Certificate of Deposit.

Benefit to the Bank:

The Bank made loan on the Net-Net-Net leased building with a national tenant. As a substantial kicker, they got a substantial amount of cash deposited in a one-year Certificate of Deposit. That deposit provided much of the initial funding for the loan and increased the Bank’s yield on the construction loan.

KEY POINTS

Depositing money into the bank making a loan increases the yield to a bank by their lending out the amount of the deposit at a much higher interest rate. It also can make the loan safer in the mind of the representatives of the bank.

Sometimes the deposits made are in checking account balances with an agreement to leave the funds for a specific period of time and sometimes in a Certificate of Deposit with the same kind of agreement. There are also other financial instruments that a bank may consider as alternatives.

A bank might require that a loan be additionally secured by the deposits or they might not. This all depends on the situation of the real estate, the bank, and the borrower. It also depends upon the negotiation among all parties.