The Brave New World of Seller Financing

THE BRAVE NEW WORLD OF SELLER FINANCING:

Monetizing the Paper and Navigating Accounting, Regulatory and Tax Traps

Mason W. Stephenson W. Todd Holleman R. Terry Carroll II King & Spalding LLP www.kslaw.com I. Introduction.

The January/February 2010 issue of Probate & Property includes an article by Jeffrey Usow and Jade Earl Newburn “explor[ing] the practical, strategic, economic, legal, and tax issues that sellers and buyers of commercial real estate should consider when deciding whether to engage in a seller-financing transaction.”1 Usow and Newburn’s article provides a framework within which a seller can evaluate whether it should offer seller financing in connection with the sale of a particular asset, how it would structure any such financing, and a basis from which a seller could approach the regulatory and tax considerations that may arise with a seller financed transaction. The purpose of this article is not to revisit Usow and Newburn’s discussion, but rather to expand on the foundation they have laid. To that end, we have attached a copy of the Usow and Newburn article at the end of this article.

This article will first explore the prevalence, or lack thereof, of the use of seller financing in today’s commercial real estate market before moving on to a brief discussion of the regulatory, accounting and documentation issues presented by seller financing transactions. Finally, the article will conclude with a look at certain issues that arise in recent seller financing transactions in today’s market.

II. Commercial Real Estate Lending Market Today.

It is no secret that today’s market for commercial real estate, while not having yet experienced the collapse that many expected, is not as robust as the market from earlier this decade, to say the least. From the early to middle parts of the decade until the summer of 2007, leverage levels were higher and capitalization rates were lower than those seen today. In the first quarter of 2003, for example, Moody’s Investment Services reported that “The average Moody's loan-to-value (LTV) for conduit loans was 90.5 percent, and this is the first time the average has been in excess of 90 percent since our study commenced in 1998. Seven percent of the first- quarter 2003 loans exceeded 100 percent Moody's LTV.”2 In today’s market, refinancing those loans made in the early to middle parts of the decade will occur, if at all, at a loan-to-value ratio much closer to 65 percent or less. In addition, many, if not most, of those loans were based on asset values that may have declined by 40% or more at the time refinancing is required. As a result, it becomes obvious that for some owners finding adequate refinancing will be impossible.3

1 Jeffrey A. Usow and Jade Earl Newburn, The Return of Seller Financing for Commercial Real Estate?, PROBATE & PROPERTY, January/February 2010, at 51.

2 CMBS Deals Show Less Diversity, Higher Leverage, ALLBUSINESS, June 1, 2003, http://www.allbusiness.com/personal-finance/real-estate-mortgage-loans/563656-1.html. 3 See generally, Steve Bergsman, There Is MONEY Out There, MORTGAGE BANKING, January 2010, at 68.

2 III. Extend and Pretend.

There are $1.7 trillion in commercial mortgages and construction loans outstanding, of which $1.4 trillion is set to mature over the coming three years. While refinancing may be unavailable for many of these loans, lenders have been willing to engage in what is known colloquially as “extend and pretend” and, in doing so, have been able to avoid a spike in commercial mortgage defaults and foreclosures. Extend and pretend, or restructuring, is often a win-win for the borrower and the lender: the borrower is able to avoid default, and the resulting foreclosure, and the lender is able to minimize its reserves required to cover future losses. This is possible, at least for banks, because accounting standards do not require a bank to write the value of the asset down when restructuring the loan. The Federal Financial Institutions Examination Council promulgated guidelines for loan restructurings in October 2009 that allowed that “renewed or restructured loans to borrowers who have the ability to repay their debts under reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.”4 As a result, first quarter 2010 restructuring levels for bank-held commercial mortgages were three times 2009 levels and seven times 2008 levels. Though the guidelines were issued as a result of regulators’ concerns about the amount of commercial mortgages coming due, and the ability of borrowers to repay or refinance, regulators have since clarified that the guidelines were intended “to promote both prudent commercial real-estate workouts by banks and balanced and consistent reviews of these loans by the supervisory agencies,” not “as a form of forbearance.”5 It remains to be seen whether these clarifications will cause a reduction in the incidence of extending and pretending.

Even if banks are able to work with borrowers to restructure debt at current levels, there will certainly remain many borrowers that will be unable to restructure and will be required to refinance or lose their property to foreclosure. Added to those are the many borrowers whose mortgages are pooled together in commercial-mortgage-backed securities (CMBS). There are $700 billion in CMBS outstanding, including $153 billion in loans that are set to mature by 2012. Though new tax regulations released by the Treasury in September 20096 make it easier to restructure these loans by allowing modification before a loan goes into default, special servicers are still unable to extend and pretend at the same rate at which banks are restructuring given the servicing standard imposed on special servicers under most pooling and servicing agreements

4 FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL, POLICY STATEMENT ON PRUDENT COMMERCIAL REAL ESTATE LOAN WORKOUTS at 3(October 30, 2009), http://www.ffiec.gov/guidance/cre103009.pdf.

5 Carrick Mollenkamp and Lingling Wei, To Fix Sour Property Deals, Lenders ‘Extend and Pretend’, WALL ST. J., July 8, 2010, at A1, available at http://online.wsj.com/article/SB125167422962070925.html. 6 Rev. Proc. 2009-45, 2009-40 I.R.B. 471.

3 that require the special servicer to maximize the timely payment of principal and interest on a net present value basis and in the best interests of all certificate holders, as a collective whole. In addition, most pooling and servicing agreements will grant to a control party (usually the holder of a majority of the most subordinate class of certificates) approval rights over loan modifications. While it often is in the best interest of the junior certificate holders to extend and pretend, increasing the possibility that the loan will be repaid in full at the extended maturity date and thus that the junior certificate holders will be paid in full, the opposite is often true of the senior certificate holders, who are much more likely than the junior certificate holders to receive their full return in the event of a foreclosure sale. Perhaps because of this, and despite the new Treasury regulations, $90 billion in CMBS loans could be in default by the end of 2010,7 with some $65 billion already delinquent.8 Deutsche Bank estimates that by the end of 2012 there will be $153 billion in CMBS loans coming due, with more than $100 billion of them being difficult to refinance.9 These loans have cash flows sufficient to cover their current debt payments, but the value of the underlying asset has decreased to a point where extending and pretending is no longer a viable option.10

Whether their mortgages are held by banks or pooled with others in a CMBS, those borrowers for whom restructuring is unavailable must find another way to satisfy their loan obligations or face foreclosure. Traditionally, of course, such borrowers would refinance their loans at their maturity, and obtaining refinancing would be no more difficult than was obtaining the original loan. In today’s market, however, such is not the case. The Wall Street Journal recently reported a study by Realpoint which found that over a three month period in 2009 borrowers for 281 CMBS loans valued at $6.3 billion were unable to obtain refinancing at maturity, including 173 loans valued at $5.1 billion whose underlying assets were producing enough money to service their debt.11

Compounding borrowers’ difficulty in finding refinancing is the increased tightness in the credit markets caused by the decline in the CMBS market. Half of all commercial real estate

7 Worst Case Scenario? Delinquencies North of 11%, Realpoint Says, REAL ESTATE FINANCE & INVESTMENT, July 5, 2010, at 3.

8 CMBS Delinquencies Move Up Again, REAL ESTATE FINANCE & INVESTMENT, August 2, 2010, at 3; but see Securitized Loan Losses Set to Rise, REAL ESTATE FINANCE & INVESTMENT, August 2, 2010, at16 (noting an increase in modifications of CMBS loans in the first half of 2010). 9 Lingling Wei and Peter Grant, Commercial Real Estate Lurks as Next Potential Mortgage Crisis, Wall St. J., August 31, 2009, at A-2, available at http://online.wsj.com/article/SB125167422962070925.html.

10 See generally Securitized Loan Losses Set to Rise, REAL ESTATE FINANCE & INVESTMENT, August 2, 2010, at 1 (“There have been 106 loans with a loss of more than 90% in 2009 and 2010 and 61 loans with a loss of greater than 100% in 2009. Year to date, there have been losses of more than 1 00% for 45 loans.”).

11 Id.

4 deals between 2002 and 2007 were financed using CMBS, while only 10 percent received such financing in 2009.12 The limited availability of CMBS financing has caused borrowers to turn increasingly to life insurance companies and local and regional banks. For best-in-class properties, this has been a workable solution,13 but for the remainder of the market, the capital has not been available or has been available only at terms which do not work in the context of the deal.14 For those borrowers whose loans are maturing and are not underwater, then, disposing of the underlying asset may provide the best avenue through which to satisfy their loan obligations.

IV. Seller Financing.

For many of the same reasons that an owner cannot refinance its commercial mortgage, a potential buyer also faces difficulty in obtaining financing. With the credit markets tight and loan availability being generally limited to transactions requiring a 65 percent loan-to-value ratio or less, a prospective buyer must find some way to finance its purchase that often requires a substantial equity investment. In this regard, as Usow and Newburn discuss, a property owner may be able to assist a potential buyer by offering seller financing for all or part of the purchase price.

Impediments to Seller Financing.

Given the number of nonearning loans and other real estate owned (OREO) currently held by many financial institutions combined with the overall tightness of the credit markets, then one would expect to see a significant volume of seller financing transactions. However, a search of the securities filings of banks with the largest holdings of nonearning loans and OREO found only one bank, East West Bancorp, disclosing a willingness to provide seller financing to purchasers and only one disclosure of an actual sale utilizing seller financing.15 Additionally, when providing seller financing to buyers, East West Bancorp requires a 30 percent down payment, and although that amount is negotiable, the Bank cites accounting rules requiring that a minimum down payment for the loan is to be treated as an accruing asset.

Anecdotal evidence suggests that few financial institutions and other commercial real estate investors are currently willing to offer seller financing as a means to effect the sale of

12 Bergsman, supra, note 3Error: Reference source not found. 13 Indeed, for such properties the CMBS market may be slowly beginning to revive. See Jonatham Sederstrom, Banks Edge Cautiously Back Into Commercial Mortgage-Backed Bonds, N.Y. TIMES, June 29, 2010, http://www.nytimes.com/2010/06/30/realestate/commercial/30cmbs.html. 14 Bergsman, supra, note 3Error: Reference source not found. 15 See East West Bancorp Inc. Form 10-K filed on March 1, 2010 for the period ended December 31, 2009, and ViewPoint Financial Group Form 10-Q filed on May 7, 2010 for the period ended March 31, 2010.

5 owned real estate.16 Many financial institutions, especially those with concentrations of nonearning assets, including OREO, are under internal or external directives to reduce their overall exposure to commercial real estate. If a seller provides seller financing to a buyer for all or a part of the purchase price, the purchase money loan remains on its books as an asset, and although its overall real estate investment would have been reduced by the amount of any down payment, the seller financed portion of the sale price remains a commercial real estate loan and an asset on its books. This can be an issue for both institutional lenders and banks and other real estate investors that must reduce their exposure to commercial real estate. The inability to remove the asset completely form their books was the most cited reason in an informal survey of both institutional lenders and investors as to why seller financing is not more prevalent.

Unless these institutions are able to monetize and dispose of the purchase money loans created as part of the seller financing transactions, either through a viable secondary market or a revived CMBS market, many banks and institutional lenders have little incentive to provide seller financing and would prefer to insist upon all cash sales financed through third-party loans in order to reduce their exposure to commercial real estate. If, however, the CMBS market revives and banks and institutional lenders are able to dispose of these purchase money loans through this mechanism, then we can expect to see an increase in the use of seller financing as a means of asset disposal.

In some instances, regulations provide a hurdle to seller financing. Legal title to most of the $153 billion in CMBS loans coming due over the next two and a half years is held by real estate mortgage investment conduits (REMIC). As discussed above, REMICS are more likely than banks to foreclose on a mortgage rather than extend and pretend due to the competing interests of the junior and senior bondholders and the applicable servicing standard. As Usow and Newburn note, REMICs are required to dispose of property obtained through foreclosure within three years after taking title. In doing so, REMICs are not allowed to offer seller financing, as doing so would constitute the offering of a new mortgage, which REMICs are not allowed to do more than three months after their “start up date.”

In their article, Usow and Newburn explore the use by REMICs of “short sales” to avoid this result, in which, rather than foreclosing or taking a deed in lieu of foreclosure that would require the REMIC to sell the asset in an all cash transaction, the REMIC works with the existing borrower and a purchaser to facilitate a sale of the property and a restructuring of the existing loan that may include an extension of the maturity date, a reduction in interest rate and a write- down of the principal balance of the loan, all so long as the requirements of the servicing

16 But see Deutsche Bank’s sale of the former Macklowe Properties, Inc.’s Worldwide Plaza in Manhattan for a reported $605 million, a transaction in which the Bank provided the buyer with a $410 million loan. Bergsman, supra, note Error: Reference source not found.

6 standard and the REMIC tax requirements can be satisfied. Anecdotal evidence confirms that a number of these “short sale” transactions by REMICs are taking place in the market. For example, to facilitate the sale of two Dallas apartment complexes that had been assumed by the special servicer, the special servicer reduced the loan balance from $41.2 million to $23 million and extended the term of the loan by four years.17

Maturity date extensions are generally limited in the pooling and servicing agreement to an outside date determined by reference to the so-called “rated final distribution date”. For most CMBS transactions, the rated final distribution date is 30 years or later after the securitization closing date and maturity date extensions are permitted up to a date two years prior to the rated final distribution date. Accordingly, for most CMBS loan pools, the more limiting factor for maturity date extensions will be the net present value analysis.

Efforts have been made to amend the regulations altogether, making these “short sales” unnecessary. The American Special Servicers Association has sought a rule change that would permit special servicers to offer seller financing in their disposition of assets acquired by REMICs through foreclosure or a deed in lieu of foreclosure. These efforts are unlikely to succeed, however, as the IRS has indicated a willingness to change the rules only if both the senior and junior certificate holders can agree. In much the same way as the two groups have competing interests when considering a restructuring, their interests are in conflict with respect to seller financing: permitting seller financing increases the likelihood that the junior certificate holders would see an increase in their return at the expense of the senior certificate holders that would be better protected by disposing of the asset at a cash price reduced enough to entice a buyer and a third party lender, but still high enough to cover the senior certificate holders’ interests.

State Licensing Requirements.

Licensing regulations, however, do not seem to provide much of a barrier to a seller seeking to offer seller financing. While, as Usow and Newburn note, at least 13 states impose mortgage lender licensing requirements, a wide variety of exceptions to these requirements exist that would exempt many sellers from being required to obtain a license in order to engage in seller financing. Arizona,18 Colorado,19 Florida,20 and Nevada21 each specifically exempt from

17 Fund Buys Apartments at Big Discount, REAL ESTATE FINANCE & INVESTMENT, July 14, 2010, at 3. 18 Ariz. Rev. Stat. § 6-971 et seq. 19 Colo. Rev. Stat. Ann. § 12-61-901 et seq. 20 Fla. Stat. § 494.001 et seq. 21 Nev. Rev. Stat. § 645E.020 et seq.

7 their license requirements sellers who engage in seller financing; California,22 Delaware,23 Mississippi,24 Rhode Island,25 and Utah26 each exempt lenders who make less than a specified number of loans per year; and the District of Columbia,27 Iowa,28 Minnesota,29 New York,30 North Carolina,31 Ohio,32 Rhode Island,33 and Vermont34 provide exceptions based on the value of the loan. Of course, banks and other institutional lenders likely would have no need to avail themselves of these exceptions, as they are likely to have already been licensed in states that so require.

Accounting Requirements - Revenue Recognition.

The Usow and Newburn article discusses the installment sale tax rules in the context of a property sale involving seller financing. However, tax treatment may differ from the treatment afforded a sale involving seller financing for financial reporting purposes. Although a lawyer is not normally charged with knowledge of accounting principles and requirements, some background will assist the lawyer in advising clients in connection with seller financing transactions.

An owner of commercial real estate, especially a publicly traded company, that provides seller financing to facilitate its sale of commercial real estate, will want to be able to recognize the full amount of revenue from the sale, especially if the transaction results in a gain.

The Financial Standards Accounting Board (FASB) Accounting Standards Codification (ASC) 360-20 provides the primary guidance for reporting revenue from the sale of real estate.

22 Cal. Fin. Code § 22000 et seq. (license not required if no more than 1 loan is made in a 12 month period). 23 Del. Code Ann. tit. 5, § 2202 (license not required if no more than 5 loans are made in a 12 month period). 24 Miss. Code Ann. § 75-67-101 (license not required for an “occasional lender not regularly engaged in the business of lending money”). 25 R.I. Gen. Laws §§ 19-14, 19-14.1 (license not required if no more than 5 loans are made in any consecutive 12 month period). 26 Utah Code Ann. § 70D 2-101 et seq. (license not required if no more than 4 loans are made per year). 27 D.C. Code Ann. § 26-901 et seq. (license not required for loans with a value greater than $25,000). 28 Iowa Code Ann. § 536.1(license not required for loans with a value greater than $25,000). 29 Minn. Stat. § 56.01 et seq. (license not required for loans with a value greater than $100,000). 30 N.Y. Comp. Codes R. & Regs. tit. 3, §401(license not required for loans with a value greater than $50,000). 31 N.C. Gen. Stat. Ann. § 53-166 et seq. (license not required for loans with a value greater than $10,000). 32 Ohio Rev. Code Ann. § 1321.02(license not required for loans with a value greater than $5,000). 33 R.I. Gen. Laws. §§ 19-14, 19-14.1(license not required for loans with a value greater than $25,000). 34 Vt. Stat. Ann. tit. 8, § 2200 et seq. (license not required for loans with a value greater than $1,000,000).

8 Revenue from the sale of real estate will be recognized when all of the following conditions have been satisfied:

o The sale has been consummated;

o The buyer’s initial and continuing investments in the property are sufficient to demonstrate a commitment to pay for the property (for example, in the case of office and industrial buildings leased on a long-term basis to tenants with satisfactory credit and with cash flow currently sufficient to service all indebtedness, a down payment of at least 10% is required, while for all other multi-tenant office and industrial buildings a down payment of at least 20% is required);

o The seller’s receivable is not subject to future subordination; and

o The seller has transferred to the buyer the customary risks and rewards of property ownership.

In determining the amount of revenue, an important term in ASC 360-20 is “sales value” which can be impacted by the economic terms of the seller financing provided. Sales value is the sum of the (i) stated purchase price plus (ii) other proceeds that are substantively additions to the sales price, less (iii) any discount necessary to reduce the seller financing receivable to its present value based on current market rates commensurate with the risk involved and (iv) the value of any services provided by the seller for which no compensation is paid.35

As noted above, if the terms of the seller financing provide that the seller will subordinate its purchase money mortgage to additional third-party financing obtained by the buyer in the future, for example, to finance subsequent tenant improvements and leasing commissions or to finance future construction, then the “sale” may not be treated as a “sale” for financial reporting purposes even though the seller will be deemed to have “sold” the property for tax purposes. In such a scenario, the seller must recognize the profit under the cost-recovery method.36 Under this method, no profit is recognized until the seller has received payments from the purchaser sufficient to cover the cost to the seller of the asset.

In addition, “below market” economic terms will result in the value of the note being adjusted downward from par to its prevent value. For example, if the seller in connection with the sale of an office building agreed to provide the buyer with a loan at 95% of the purchase

35 See Ernst & Young, FINANCIAL REPORTING DEVELOPMENTS - REAL ESTATE SALES (December 2009), http://www.ey.com/Global/assets.nsf/United%20Accounting/ATG_FRD_BB1884/$file/ATG_FRD_BB1884.pdf.

9 price at an interest rate of 5% per annum over a 20-year term, when the “market” for similar third-party loans was 80% LTV at an 6.5% rate over a 10-year term, then the “sales value” assigned to the note would be less than its face value.

Since buyers in seller financed transactions often expect and demand “better than market” economic financing terms, then providing such financing to a buyer will often result in the seller recognizing less gain (or more of a loss) in addition to whatever discount the seller has already accepted in terms of the actual stated purchase price for the property.37

Documentation/Negotiation - Issues.

Because many seller financing transactions are conducted in the context of “as-is” sales, the documentation process for the loan portion of the transaction is distinct from the typical real estate finance transaction. In an arm’s length loan negotiation, requirements with respect to representations and warranties, appraisals, environmental diligence and non-recourse carve-outs, with some exceptions depending on the lender and underlying transaction, are well-established and a “market” standard with respect to such issues has evolved over time. However, given the unique characteristics of a seller financing transaction, these requirements are usually the subject of the most negotiation between the parties.

Most lenders have established loan documentation containing their standard required representations and warranties. Such representations and warranties would typically cover issues such as due organization, power and authority, enforceability, litigation, taxes, compliance with law, no conflicts, no liens, taxes, insurance, access, solvency, leases and SPV status. For a borrower that has a history with the underlying property, negotiations with respect to representations and warranties often turns on whether such provisions will have materiality modifiers or knowledge qualifiers with respect to actions or agreements of third parties (i.e., lessees or property managers). In the seller financing context, borrowers often ask for blanket knowledge qualifiers or are often unable or unwilling to even make some of these representations and warranties.

For example, a borrower may request that any representation and warranty as to the existence of litigation or liens or the payment of taxes be based solely on its knowledge, based upon a review of a pre-closing search of the relevant tax, judgment and lien records. Normally, this would be untenable for a lender, but in the seller financing context, a lender should be able to get comfortable with such modified representations and warranties as a result of its ownership

37 See, e.g., ViewPoint Fin. Group (Form 10-Q) (May 7, 2010) (reporting seller financing provided in connection with the disposition of an outlet mall in Texas that was previously OREO and is considered “substandard” due to its 90% LTV ratio).

10 and history with the property. Similarly, a lender taking an equitable approach to negotiations would not require a borrower to provide representations as to property condition and leases.

One area that a seller should focus on with particularity is any representation and warranty as to solvency. In the context of a seller financing of an income-producing property following a foreclosure or deed-in-lieu transaction, often the reason the seller has possession of the property is due to poor financial performance. Given the current climate of high vacancy rates, tenant defaults and diminishing property values, borrowers may think twice about providing the typical solvency representation that the fair saleable value of the property (after giving effect to the financing) exceeds total liabilities of the borrower. Borrowers will often suggest an inability to establish a “fair saleable value” for a property, given the general lack of activity in the commercial real estate market. However, the sales price established by the underlying transaction between borrower and lender should be sufficient to allow the borrower to make the required representation and warranty and any request by borrower to modify or remove a solvency representation should be met with skepticism given the buyer’s prior negotiated agreement to pay the agreed upon purchase price.

Another area of focus for a lender in non-recourse seller financing transactions should be any request to limit or remove standard “bad boy” recourse provisions. Often borrowers will object to provisions that require the borrower to indemnify lenders for misapplication of rents, environmental liabilities and mishandling of tenant deposits. The issues of tenant deposits and misapplication of rents are easily handled by limiting liability to the period of time in which buyer owns and controls the property. However, the question of environmental liability is a closer question. Typically, in the arm’s length deal a lender would not limit the borrower’s obligations to indemnify it for environmental liability resulting solely during the period in which the borrower owns and controls the property. In the seller financing context however, the lender has controlled the property for some period of time and environmental liability could have occured as a result of its actions or inactions. It is only fair for a borrower or guarantor to ask that its obligations be limited so that it is not responsible for environmental liabilities caused by the lender.

The tougher issue, however, is if something occurs during the period that lender owned the property that was neither caused by the lender nor resulted from the lender’s negligence or inaction and/or the lender has no knowledge of the events causing the issue. It is clear that careful thought must be given by both parties in negotiating the borrower’s or guarantor’s indemnity obligations with respect to environmental liabilities.

11 Finally, one over arching concern all lenders must keep in the back of their mind when entering into any seller financing transaction is lender liability. Lender liability is an umbrella term that covers many different types of claims asserted against a lender, many of which can result from a lender’s control over a borrower, its unfair dealings with the borrower or its complicity with the borrower’s bad acts. Claims can be brought against a lender not only by a borrower but also by its creditors. For example, a lender may have concern that a claim may be brought against it by a borrower’s other creditors as a result a transaction which benefits such lender but is to the detriment of such other creditors. In addition, in administering the loan a lender should be careful in calling defaults as a result of events or conditions known to it due to its prior ownership of the property but not fully disclosed to borrower until after consummation of the sale. Although successful lender liability claims are rare, because a period of ownership prior to becoming a lender is inherent in all seller financings, a lender must be keenly aware of the potential for any such claims.

V. Summary.

The Usow and Newburn article provides excellent guidance to any owner and its lawyer interested in facilitating property sales in an otherwise constrained real estate finance environment. Even though many factors are in play that should encourage a large volume of seller financed transactions, those transactions have not materialized, and are not likely to materialize, until the return of secondary markets, including CMBS, in which sellers are able to monetize and dispose of purchase money loans and reduce their overall exposure to commercial real estate.

12 THE RETURN OF SELLER FINANCING

FOR COMMERCIAL REAL ESTATE?

By Jeffrey A. Usow and Jade Earl Newburn

Probate & Property January/February 2010

Since late 2008, the global financial markets have been under incredible, and perhaps unprecedented, strain. Lenders have decreased their lending activity, in part as a result of the collapse in value of commercial mortgage-backed securities and derivatives.

Despite the credit crisis and the general lack of credit from third-party lenders, owners of commercial real estate assets may need or desire to sell them and generate liquidity in their portfolios in the near term. For example, owners of real estate assets may need to sell to generate cash for business operations, for debt repayment, or to satisfy redemption requests from their investors.

“Seller financing,” which was last popular during the period of high interest rates in the late 1970s and early 1980s, may provide a means to bridge the financing gap facing buyers and sellers of commercial real estate assets in today’s market. As the term is used in this article, seller financing is a transaction in which the seller makes a secured loan to the buyer to finance a portion of the property’s purchase price. The two most common forms of seller financing are loans secured by a lien on the underlying real estate (for example, traditional mortgage loans) and mezzanine loans (loans secured by a pledge of the ownership interests in the purchasing entity). Contracts for deed, in which the seller conveys title to the buyer on receipt of the purchase price, may be another available seller-financing option, but they are generally not used in the commercial real estate context and are beyond the scope of this discussion.

In the right circumstances, seller financing can increase the number of qualified buyers and potential transactions. Negotiations of interest rate, maturity date, and other loan terms in seller financing permit creativity in deal making and the potential for “win-win” outcomes. Sellers that finance sale transactions may be able to close more quickly than an institutional lender, because the seller will likely not need to conduct the same amount of due diligence on the collateral as a third-party lender. Certain creditworthy buyers may be able to use seller financing to acquire real estate with more favorable financing terms than those of other lenders.

This article explores the practical, strategic, economic, legal, and tax issues that sellers and buyers of commercial real estate assets should consider when deciding whether to engage in a seller-financing transaction. It also considers the use of seller financing in the context of the sale of an asset that is subject to a defaulted mortgage.

Deciding Whether to Become a Lender

As a threshold matter, each seller must consider its reasons for selling, its need for liquidity, whether it has the power and authority to become a lender, and how it will service any seller-financed loan.

First, a seller should evaluate its reasons for selling an asset in the current environment. For example, is it attempting to discharge property debt that it is unable to refinance? Is it trying to generate liquidity for its overall portfolio? Or, perhaps less likely, is it attempting to convert its real estate assets into a portfolio of loans that are secured by real estate? For example, if the cash proceeds from the sale of a commercial real estate asset are sufficient to repay the existing debt on that asset, the seller may be willing to use the cash to first repay the outstanding loan, then accept payment of any remaining proceeds over time in the form of a loan, particularly if the loan is for a short term with limited extension rights. But, if a seller is looking to generate liquidity for its overall portfolio, then the seller must determine the extent to which it may be able to monetize its interest in its seller-financed loan by selling all or part of its interest in the loan on the secondary market.

Before engaging in lending activity, a seller also must review its organizing documents, joint venture agreements, fund agreements, upper-tier debt agreements, and statutory and regulatory obligations, as applicable, to confirm that it is permitted to make and hold loans. To the extent that a seller does not have authorization, it must amend or otherwise modify its organizational documents or obligations. Further, as discussed below, each seller must ensure that it complies with applicable lending laws, including state licensing, restrictions on collections practices, and other lender obligations.

Finally, a seller must consider the extent to which it has the underwriting and monitoring capability to effectively originate and service individual loans or a loan portfolio. To the extent that a seller focuses its efforts on owning and managing real estate assets, the seller needs to either build its internal capabilities or find an appropriate loan servicing agent. A sophisticated seller, however, may be able to service a limited number of loans.

14 Seller-Financing Structures

If the threshold questions of necessity, power and authority, and servicing capability are satisfactorily addressed, then a seller should consider the structure of a seller-financing transaction.

The key variables in determining the appropriate structure of a seller financing transaction are the percentage of the purchase price that the seller must receive in cash at closing and the percentage of the purchase price that the buyer is prepared to pay in cash at closing.

In the simplest case, the purchaser pays a portion of the purchase price, for example, 50%, with its own cash and the seller finances the remaining 50% of the purchase price. This structure is most likely to be used by funds or other entities that own real estate assets subject to little, if any, debt. Alternatively, the buyer may borrow a portion of the purchase price from a third-party lender, which is secured by a first priority lien on the asset, and another portion of the purchase price from the seller, which is secured either through a second priority lien on the asset or by a pledge of the ownership interests in the buyer. As an example of this deal structure, a third-party lender loans 50% of the purchase price secured by a mortgage on the property in first position, the seller loans 30% to 40% of the purchase price secured by a mortgage in second position (or as a mezzanine loan), and the buyer provides cash at closing of 10% to 20%. In this example, the seller receives 60% to 70% of the purchase price at closing and the buyer obtains an aggregate loan-to-value ratio of 80% to 90%.

With the cumulative leverage of both a senior loan and a junior loan, a buyer may be able to maintain a relatively high debt-to-equity ratio (with the potential to earn greater yields on its equity investment) and may be more likely to enter into commercial real estate transactions in today’s tight credit market. Given its increased default risk as a junior lender, a seller may be able to charge a higher interest rate than the senior lender, which may provide a net economic gain.

If a seller wants to sell multiple assets, it should consider setting up a program with third- party lenders that are willing to lend in first position and permit the seller to finance the purchase price gap with a junior loan. By doing so, the seller may be able to pre-negotiate the intercreditor agreement and subordination agreement that the lender and seller should require and present a prospective buyer with a complete financing solution during the negotiations of the purchase agreement.

15 Choice of Asset

A seller should consider several factors when deciding whether to offer an asset for sale in a seller financing transaction. To a large degree, the buyer, seller, and third-party lender all want the asset to be as financially healthy as possible, because a strongly performing asset increases the likelihood of both equity returns and debt repayment. In addition, if the existing loan secured by the property is not yet due, the seller must have the right to prepay it without a significant penalty. The seller should also understand whether any other contractual payments are due on the sale of the property. Unless the seller (or the seller’s parent) is willing to contribute equity at the closing or the seller-financed loan is sold as of the closing, the cash proceeds from the sale must be sufficient to discharge the existing debt. If the cash proceeds received by the seller from the buyer’s equity contribution and the buyer’s third-party lender are insufficient to repay the existing debt on the property, a seller can attempt to generate additional cash by selling a portion of the seller-financed loan at the time of the closing; however, the purchase and sale agreement should not obligate the seller to do so. Given present market conditions, the authors believe that it is very unlikely that this solution will work in practice. Alternatively, it may be possible to convince the senior lender to accept partial payment of its debt, to allow the buyer to assume the remaining portion of the loan, and to allow junior liens to attach at closing. The existing lenders should be contacted as early as possible to determine the feasibility of this option.

Monetizing the Seller’s Interest

A seller has two basic options to monetize or otherwise realize the economic benefits of its interest in a seller-financed loan: hold the loan to maturity or sell part or all of the loan on the secondary market (either simultaneously with or after the closing of the property’s sale). A seller may be willing to wait to be repaid if, for example, the loan is short-term or the seller is not relying on the sale to generate present liquidity. Conversely, if a seller desires or needs to sell part or all of its interest in the loan, the loan should be structured to allow the seller to receive a price as close as possible to the par value of the loan and avoid material discounts.

The seller has at least four potential ways of selling its interest in the loan: sell the entire loan at one time, syndicate the loan (that is, enlist at least one additional lender to make a part of the initial loan to the buyer and receive its own note), form a joint venture to originate (or later acquire) the loan, or sell participation interests in the loan. A seller should be able to minimize discounts to the par value of the loan by selling the entire loan at one time, as any discounts associated with such a sale should be based only on the condition of the asset and the creditworthiness of the buyer. Discounts to par value also should be modest or nonexistent if the

16 seller syndicates the loan or forms a joint venture with another party to make the loan, because the buyer or holder of such interests has recourse to the asset and the borrower (through the provisions of the applicable loan or joint venture agreement) and is involved in the initial underwriting and pricing of the transaction. The potential for discounts is likely to be greatest in the sale of participation interests in the loan because the participation buyer’s rights to the economic benefits of the loan are only contract rights with the seller, and as a result, the risk that the seller will default may cause the price of such participation interests to be discounted from their par value.

It may be difficult, if not impossible, for the seller to mitigate certain factors that can influence the value of the seller-financed loan on the secondary market. For example, to the extent that purchasers of such interests desire for a loan to be “seasoned” (that is, to have been on the books for a period of months or years with a good payment record), the price of interests in a relatively unseasoned loan can be discounted if an adequate borrower payment history has not been established. Similarly, although the seller has the capability to choose the property being sold and is in control of the decision of whether to offer seller financing to any particular buyer, the seller cannot control changes in either the asset or the buyer after the closing.

Absent further fact-specific investigation, it is quite difficult to know the terms under which a particular seller-financed loan may be sold. Evidence suggests that investment funds and other purchasers of debt are beginning to increase their rate of acquisition of loans in the secondary market. Given the number of distressed real estate projects, however, such buyers may look first to acquire distressed debt at a substantial discount before looking to purchase seller-financed debt at minimal discounts. As a result, a seller may need to hold its seller- financed loan longer than it would otherwise desire.

Loan Documentation

Regardless of which monetization strategy the seller wishes to use, the seller should document its loan as if the seller were a third-party lender to avoid discounting the price of the loan in the secondary market because the loan was not made on “market” terms. Accordingly, a seller should obtain not only a note and a mortgage on the sold property but also a lender’s title insurance policy with appropriate endorsements; a guaranty from a creditworthy party (which, depending on the structure of the transaction, can be either a nonrecourse carve-out guaranty or a payment guaranty); an environmental indemnity; an assignment of leases and rents; opinions from borrower’s counsel; financial covenants and special purpose entity restrictions; subordination, nondisturbance, and attornment agreements; and escrows for taxes and insurance premiums. If the seller is a junior lender, it also may want to insist that all operating revenues be

17 placed in a lockbox subject to a deposit control agreement to give it a security interest in the rents and profits from the property. The terms of such an agreement would need to be negotiated with the buyer’s senior lender. Mezzanine loan documents should include typical mezzanine lender protections, such as a pledge of the ownership interests of the property-owning entity; special purpose entity covenants; and the requirement that independent directors approve certain entity decisions. In certain circumstances, particularly when the seller knows that it will not attempt to market its interests in the loan or if the loan is short-term with limited extension rights, it may be possible for the seller to accept less than the full set of documents. The seller also might accept certain provisions that are not customarily contained in third-party loan documents. These efforts can facilitate speed and efficiency in the transaction but should be done only after consultation with legal counsel.

In negotiating the transaction, the seller will find it very important that the seller retain the unencumbered right to sell syndication and participation rights in the note, security instrument, and the other loan documents; that the promissory note and security instrument contain a “due on sale” provision, which provides that the loan is immediately due and payable on the direct or indirect sale or future encumbrance of the property or a change in control of the buyer; and that a creditworthy entity guarantee the debt to the extent possible given the structure of the transaction.

A sophisticated buyer, on the other side of the transaction, may realize that seller financing provides unique leverage points that it can work to its advantage and that would not be available had it borrowed from a third-party lender. For example, a common provision in a real estate purchase and sale agreement allows the buyer to sue the seller for damages on a breach of the seller’s representation or warranties (often capped at a certain amount). In the context of a seller-financing transaction, a buyer may seek to “secure” its ability to recover any such damages by negotiating a set-off provision in the promissory note. If the representation is incorrect and the buyer suffers certain damages, this set-off provision allows the buyer to reduce the amount it owes under the promissory note by the damages instead of being required to sue the seller. A seller must be cautious when granting such a right because these rights are not commonly included in third-party loans. As an alternative to a set-off right, a seller may be able to provide the buyer with a guaranty of its representation and warranty obligations from an acceptable entity. To the extent a set-off right is ultimately included in the loan documents, the seller may be able to limit the discount on sale of the loan that would result from the set-off right by guaranteeing to pay to the loan purchaser any shortfall of the loan proceeds that results from the buyer’s exercise of the set-off right. In the alternative, the loan documents could provide that the offset is limited to the portion of the loan that is retained by the seller.

18 Similarly, a buyer can resist giving the seller, as lender, a full environmental indemnity on the theory that the buyer should not assume liability for conditions that the seller created or controlled during the seller’s period of ownership. Again, the seller will want a customary environmental indemnity so that the loan will be on market terms; however, it may have to consider giving greater environmental protections to the buyer in the purchase agreement than it normally would provide.

Regulatory Considerations

A seller may be subject to state or other regulatory requirements. For example, at least 13 states (Arizona, Arkansas, California, Florida, Hawaii, Maryland, Minnesota, Nevada, New York, North Dakota, Rhode Island, South Dakota, and Vermont) have lending licensing requirements that may be applicable. See Ariz. Rev. Stat. § 6-971 et seq.; Ark. Code Ann. § 23- 39-502 et seq.; Cal. Fin. Code § 22000 et seq.; Fla. Stat. § 494.001 et seq.; Haw. Rev. Stat. § 454-1 et seq.; Md. Code Ann., Fin. Inst. § 11-501; Minn. Stat. § 56.01 et seq.; Nev. Rev. Stat. § 645E.020 et seq.; N.Y. Comp. Codes R. & Regs. tit. 3, § 401; N.D. Cent. Code § 13-04.1-01.1 et seq.; R.I. Gen. Laws §§ 19-14, 19-14.1; S.D. Codified Laws § 54-14-12 et seq.; and Vt. Stat. Ann. tit. 8, § 2200 et seq. In any particular seller-financing transaction (including a sale of a seller-financed loan) the seller should investigate and analyze such laws. In California, for example, subject to certain exceptions, a seller engaging in lending activity with a sufficient nexus to California (such as the location of the borrower or the property in California) must comply with the California Finance Lenders Law. Cal. Fin. Code §§ 22000 et seq. That law requires such lender to, among other things, obtain a license from the Department of Corporations, provide a statutory bond, cooperate with possible examinations of its books and records, and file annual financial statements. Cal. Fin. Code §§ 22100, 22101, 22106, 22109, 22112, 22156, 22159, 22715. Regardless of the jurisdiction, a seller should consult with appropriate legal counsel for any legal precautions it should take to minimize liability for its actions as a lender, including those in making or negotiating any loan commitment, letter of intent, or loan brokerage agreement.

In addition, to the extent that the seller sells participation or other interests in a seller- financed loan, the seller must determine whether the interests being sold are a “security,” which requires either registration or an applicable exemption from securities laws.

Private Investment Funds

Private investment funds that own real estate face several important considerations. If the fund is subject to a stipulated liquidation date, the maturity of the loan should not extend beyond that date, unless the loan is sold either to an affiliate (subject to any applicable registered advisor

19 restrictions) or a third party before the end of such liquidation date. The fund manager also should confirm that any proposed conversion of an equity interest in real estate to a debt interest is permitted under the restrictions and covenants of any fund-level debt and determine whether the proceeds from the loan are included for purposes of calculating the management fee (under the definition of invested capital or otherwise). In addition, the fund manager should determine how the loan proceeds will be characterized for purposes of the fund’s distribution waterfall. Finally, to avoid holding plan assets subject to the Employee Retirement Income Security Act of 1974, as amended, funds with pension fund investors that operate as real estate operating companies or venture capital operating companies should consider the effect of a seller-financing transaction on the operating company status of the fund.

Tax Issues

Each party to a seller-financing transaction should engage tax counsel to identify tax concerns with the transaction. Some of the potential tax issues associated with seller-financing transactions are discussed below.

Unrelated Business Taxable Income (UBTI)

Both buyers and sellers must be cognizant of UBTI issues that arise in a seller-financing transaction. A U.S. tax-exempt entity that is a lender in a seller-financed sale generally should not recognize UBTI for interest income from the loan. But any fee income (for example, origination fees in respect of services) from the transaction may be subject to UBTI taxes.

Sellers also should be aware of the issues facing UBTI-sensitive buyers to avoid limiting the pool of potential buyers that can use seller financing. UBTI includes “debt-financed income,” which includes income to the extent that it was derived through “acquisition indebtedness.” Internal Revenue Code § 514(a)–(b). Generally, a UBTI-sensitive buyer that borrows from a seller in a purchase transaction will incur “acquisition indebtedness,” and the buyer will be liable for income taxes on the income of the property equal to the ratio of the average outstanding principal balance of the acquisition indebtedness to the average basis of the property during the taxable year. IRC § 514(a).

But certain “qualified organizations,” for example, certain corporate pension funds and educational endowments (but not private foundations), can incur acquisition indebtedness for real property without incurring UBTI, provided that certain conditions set forth in IRC § 514(c) (9) are met. Among such requirements are the following: the acquisition price of the property must be a fixed amount determined as of the date of acquisition (and not dependent on the financial results of the real property); the amount of the indebtedness (or any amount payable on

20 the indebtedness), or the time for making any payment of any such amount, must not depend on the financial results of the real property; no more than 25% of the rentable floor space of the real property may be leased back to the seller or a person related to the seller; and any financing provided by the seller or a person related to the seller must be on “commercially reasonable” terms. (Neither IRC § 514(c)(9)(G) nor the Treasury Regulations provide specific guidance or a safe harbor regarding what constitutes commercially reasonable terms.) Note that the requirement of commercial reasonableness provides an independent tax reason for the seller to, in most instances, require loan documents that are similar to those found in third-party lending transactions. Depending on the facts and circumstances of each case and in conjunction with a thorough review by tax counsel, certain UBTI sensitive investors may be able to shield most, if not all, of the proceeds of a seller-financed transaction from UBTI taxes.

Other Special Types of Sellers

In addition to U.S. tax-exempt entity sellers, other types of sellers may need to take into account special tax considerations in seller-financing transactions. If, for example, a non-U.S person is a lender in a seller-financing transaction and this non-U.S. person is treated as engaged in an active U.S. lending trade or business with respect to the loan, any income from such loan can constitute income that is effectively connected with a U.S. trade or business (ECI). A non- U.S. person will be subject to a maximum rate of 35% on any ECI and will be required to file a U.S. federal income tax return.

Moreover, if an entity that is treated as a real estate investment trust (REIT) for U.S. federal income tax purposes is a lender in a seller-financing transaction, such entity must analyze whether the loan is structured as a “qualifying asset” that generates “qualifying income” for purposes of maintaining REIT status under IRC § 856.

Original Issue Discount

The original issue discount rules of IRC § 1274 also may apply to seller financing transactions. If these rules apply, the seller would recognize interest income, and the debtor would recognize interest expense based on an economic accrual concept. Specifically, the IRS can impute interest to a seller in a seller-financing transaction if the “redemption price” of the debt is deemed to exceed the “issue price” of the debt (as determined under IRC §§ 1273(a)(2), 1273(b), and 1274(a)). If, for example, a loan does not require current interest payments that are at least equal to the applicable federal rate of interest at the time the debt is issued, additional interest would likely be imputed under the original issue discount rules. In addition, cash payments made by borrowers to lenders (designated as interest or points, for example) may cause original issue discount tax liability. Treas. Reg. § 1.1273-2(g)(2)(ii).

21 Installment Sale Rules

As a general rule, the installment sale provisions of the IRC provide that a seller may have the ability to recognize the gains associated with a sale of a real estate asset over time and thus defer the payment of some or all of its capital gains tax liability on the sale of that asset. IRC § 453. Under certain circumstances, however, a seller may be required to pay interest on the deferred tax liability, which may mitigate the economic benefits of such deferral. IRC § 453A.

Unincorporated Business Taxes

A seller may be liable for unincorporated business taxes payable in certain jurisdictions as a result of a seller financing transaction. In New York City, income derived by unincorporated businesses (such as individuals, partnerships, and limited liability companies) is subject to taxation. New York City Admin. Code § 11-501 et seq. If a seller makes more than one loan per year, there is a risk that the seller or its affiliates might be considered to be in the business of making loans and thus subject to tax. Id. § 11-502. If a seller considers a seller- financing transaction originated or negotiated in New York City, or for an asset located in New York City, it should pay careful attention to the facts and circumstances to determine whether the seller would be deemed to be in the business of lending and, if so, whether an exemption applies.

Similarly, the District of Columbia imposes unincorporated business taxes on the income derived by partnerships, limited liability companies, and other noncorporate entities in the District of Columbia. D.C. Code Ann. § 47-1808.01 et seq. Accordingly, the determination of whether the tax applies to any particular entity is solely based on the applicable facts and circumstances, including the number of transactions that the entity conducts in the District of Columbia.

Seller Financing for REMIC Short Sales

One new type of seller financing can be used for troubled real estate assets with defaulted mortgage loans. Given the troubled capital markets, lenders holding foreclosure property are discovering that, to sell the property, they need to offer seller financing.

In its simplest form, the lender or syndicate of lenders holding the defaulted loan forecloses and likely acquires title to the property at the foreclosure sale, or obtains title directly from the borrower through a deed in lieu of foreclosure. Thereafter, the lender or syndicate (now, the titleholder of the property) sells the property and offers seller financing to the new buyer of the property. The lender would have more flexibility in structuring its seller financing

22 than the seller financing described above because there would be no existing mortgage loan with a third-party lender to consider.

This approach is simple to structure if the lender or syndicate is a financial institution or other investor. If the lender holding the defaulted mortgage loan is a real estate mortgage investment conduit (REMIC), however, the approach raises other issues. A REMIC is a special purpose entity that holds a pool of commercial and/or residential mortgages in trust and issues securities in the pool of its assets to third-party investors. Under the tax rules governing REMICs, the trust that takes title to property in foreclosure or by deed in lieu of foreclosure generally must sell the property within three years. IRC §§ 860G(a)(8) and 856(e)(2). More importantly, under current tax law, when it sells the property, unlike a financial institution or other commercial lender, the REMIC cannot offer seller financing. For REMIC tax purposes, such seller financing would be treated as the origination of a new mortgage loan by the REMIC. Except in certain limited circumstances, the REMIC tax rules generally prohibit a REMIC from acquiring a new mortgage loan after the third month following the “start up date” for the REMIC. The “start up date” is the date the REMIC was established—that is, the date on which the REMIC issues all of its regular and residual interests. This “start up date” is probably long before the date the REMIC can acquire any property by foreclosure or deed in lieu of foreclosure. IRC §§ 860D(a)(4) and 860G(a)(9).

To permit a REMIC to avoid these problems in dealing with property subject to an existing, defaulted mortgage loan, the market has developed a different approach: the “short sale.” When a short sale is used, instead of foreclosure or deed in lieu of foreclosure, the lending REMIC and the borrower under the defaulted loan arrange to have the borrower market and sell the property through a process acceptable to the lender. The REMIC-lender typically will act through a special servicer charged with addressing defaulted mortgage loans held by the REMIC. The lender must approve the selling broker and determine the terms of sale. One of these terms of sale is “seller financing”—that is, the REMIC requires the buyer to assume the existing loan on modified terms. On identification of the buyer, the existing borrower enters into a purchase agreement with the buyer in which the buyer agrees to buy the property subject to the existing debt, conditioned on the consent of the REMIC. On consummation of the sale, the REMIC (as lender) and the buyer restructure the existing debt (the “seller financing”). This approach results in the following significant benefits:

• The property can be sold without the REMIC having to be concerned about the three-year holding limitation under the REMIC tax regulations applicable to foreclosure property because the REMIC would not have held title to the property at any time.

23 • The REMIC can offer the so-called “seller financing” to consummate the sale. The REMIC tax rules do not prohibit the buyer of mortgaged property from acquiring the property subject to its existing indebtedness. Treas. Reg. § 1.860G-2(b)(3)(ii) and 1.860G-2(b)(5). Moreover, a REMIC has greater ability to modify a mortgage loan when it is in default (or imminent default) without incurring adverse tax consequences. IRC §§ 860F(a)(2) and 860G(a)(3); Treas. Reg. § 1.860G-2(b)(3)(i). Those modifications, which would otherwise raise REMIC tax issues if they were entered into in connection with a loan that was not in default or imminent default, can include reducing the principal balance of the loan and modifying the maturity date, interest rate, or other payment terms under the loan.

A REMIC considering this approach must be mindful of what it will provide to the existing borrower to obtain its cooperation—such as an agreement to release guarantors. Of course, each party should consult with its own tax counsel to confirm the consequences of engaging in a short sale.

Summary

In these extraordinary times in the credit markets, buyers and sellers may be able to close the financing gap in the near term with the aid of seller financing. Experienced counsel can assist the buyer or seller in closing real estate transactions by examining the business, legal, tax, and financing issues from a strategic and a transaction-specific level.