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.
Vicki Yeomans - Klein, S.E.C. is the
owner of Yeomans Realty in Houston, Texas. Ms. Klein
specializes in property management, leasing and development
of various real estate projects.
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 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.
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 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.