Part 1 of 2
RANCHO SANTA MARGARITA, CA—In cases where landlords know their mortgage is a high-leverage loan, it could create a refinance scenario where ownership is required to inject a large amount of fresh capital, Faris Lee Investments’ Nicholas Coo tells GlobeSt.com. As we recently reported, the firm represented both buyer and seller in the sale of Plaza El Paseo at Rancho Santa Margarita Town Center, a legacy-quality shopping center here, for $56.6 million despite a $32-million encumbrance. In part 1 of this two-part exclusive feature, we spoke exclusively with Coo and Faris Lee president and CEO Rick Chichester about retail deals with encumbrances and advising clients with a challenging loan-assumption scenario. In part 2, we speak exclusively with Chichester and the firm’s Chris DePierro, about helping buyers see a long-term vision in retail properties.
GlobeSt.com: As in El Paseo’s case, how often do you see retail properties encumbered by higher than market loans that need to be assumed?
Coo: It is fairly common for properties to be encumbered due to fixed-rate debt options that carry pre-payment penalties resulting from the lender’s long-term rate commitment. In the case of conduit (CMBS) securitized financing, pre-paying the loan essentially involves unravelling a security instrument that requires “prepaying” all future interest in addition to buying replacement collateral in the form of bonds that match the remaining loan term. Sale transactions requiring loan assumptions are common due to the fact that the loan prepayment penalty exceeds the marginal value increase if the property were available without the loan or “open to new financing.” In Plaza El Paseo’s case, the defeasance cost of the existing loan would have been approximately $6.3 million. By adding the defeasance cost to the sale price, the cap rate would have been 4.7%, which made the defeasance cost prohibitive from a yield standpoint.
GlobeSt.com: If the loan is not assumed, what other options does the seller have? Is this a foreclosure risk/scenario?
Coo: As was the case with Plaza El Paseo, the seller had the option to hold, but opted to maximize the exit value due to the historically low cap-rate environment. However, in cases where landlords know their mortgage is a high leverage loan, it could create a refinance scenario where ownership is required to inject a large amount of fresh capital. This is due to changing loan-to-value limits or debt-service-coverage-ratio constraints, thus creating a high-risk scenario and a potential default or foreclosure risk.
GlobeSt.com: How do you go about advising clients with a challenging loan assumption scenario?
Coo: When advising our clients, we look at both the asset and our client’s objectives from as many scenarios as possible. What this essentially means is we look at existing loans objectively and determine if they are a value enhancement or a detractor from the asset’s net sale value. There are several cases where prepayment of the loan with penalty adds to an asset’s ultimate sale value. In order to make sure our clients understand the economics of the sale, our analysis is performed up front and accurately measures net proceeds less any prepayment penalty or loan assumption.
GlobeSt.com: How do you manage buyer and seller expectations in these circumstances?
Coo: When managing buyer expectations, we make sure they understand the cash-flow projections when assuming an existing loan, in addition to the requirements involved when assuming long-term fixed-rate debt. Overall, the loan-assumption process is lengthy and complex, and we invest substantial up-front resources to ensure the buyer is fully aware of the process, complexities and longer-than-typical closing timeframe.
GlobeSt.com: Why did you decide to take on this challenging transaction?
Chichester: First of all, we have had a long-standing client relationship with the Plaza El Paseo ownership and were very familiar with the exceptional, iconic asset. We also understand the South Orange County retail market and the unique qualities of the master-planned community of Rancho Santa Margarita. With these fundamentals as our baseline, we were able to do what we do best, which is to invest substantial time and effort in order to go deep into a rigorous investigation and property inquiry, inclusive of exhaustive property-specific underwriting, as well market-level research. Our approach and our focus is uncovering the hidden value of an asset by solving for, and overcoming, the issues and challenges that are encountered. El Paseo’s situation fit perfectly into our comprehensive, advisory approach of maximizing value through creative efforts and collaboration.