The Guardrail Report

Capital clarity for real estate owners and investors
By Robert Newstead

The Lowest Rate Loan Can Be Expensive Capital

Interest rate matters, but proceeds, execution, flexibility and prepayment penalties may matter even more.

For more than two decades, I have helped real estate owners finance properties through changing interest rate environments, credit cycles and market conditions.

One mistake that has remained remarkably consistent is that borrowers often begin by asking which lender is offering the lowest interest rate.

That is an understandable question. I'm just not convinced that it should be the first one.

A loan with a lower rate will improve debt service coverage ratios, however, there could be aspects of the loan which restrict the property’s business plan. For example, there may be requirements that need to be met that make it difficult to get tenant improvement or leasing commission dollars released. There could be prepayment penalties that make an early sale prohibitively expensive. Once those factors are considered, the lowest rate loan may become a more expensive source of capital.

The better question for a borrower to ask is which financing structure gives the property and its ownership the highest probability of success?

The Capital Decision

When comparing financing proposals, I evaluate five factors before reaching a conclusion.

#1 - Proceeds and required equity

The interest rate tells you what the borrowed capital costs. It does not tell you how much additional equity the loan will require.

Suppose one lender offers a slightly lower rate but provides $1 million less in loan proceeds. The borrower must either contribute that additional equity, bring in a new investor or reduce the scope of the business plan.

That equity has a cost even if it does not appear on the lender’s term sheet.

That additional equity could have been used to acquire another property, renovate an existing asset, reduce higher cost debt or remain available as liquidity. A lower rate loan that traps substantially more equity is not automatically the less expensive choice.

Owners should ask:

• How much cash do I need to invest under each loan proposal?
• Does the loan adequately fund leasing, renovations and reserves?
• What could the additional equity earn elsewhere?
• How much liquidity will remain after closing?

The right comparison is not simply interest expense for one loan versus interest expense for another loan. It is the total capital required under each alternative.

#2 - Certainty of execution

A term sheet has little value if the lender cannot close on the proposed terms.

Owners frequently compare written proposals as if every dollar of proceeds and every stated condition were guaranteed. They are not.

A lender may reduce proceeds following an appraisal, property condition report, environmental review or credit committee decision. It may introduce new reserves, guarantees or closing conditions. A transaction can also become delayed because the lender’s approval process is more complicated than initially represented. There could also be broader economic changes in the market that cause the lender to change the terms or potentially even walk away from the deal.

Before accepting a proposal, understand:

• Who has approved the transaction?
• What approvals remain?
• Which assumptions determine the final loan amount?
• What could cause the lender to change its terms?
• Has the lender recently closed similar transactions?
• Can it realistically meet the required closing date?

A low rate loan that closes late, or does not close at all, can become extremely costly when a purchase contract or loan maturity date are approaching.

#3 - Operational flexibility

Loan documents can affect how an owner operates a property for years.

A loan may contain restrictions involving:

• Leasing decisions
• Capital improvements
• Future advances
• Additional debt
• Cash management
• Ownership transfers
• Property releases
• Financial covenants
• Recourse and guarantee obligations

These provisions may appear secondary when the loan is being priced. They become much more important when the property or market does not perform exactly as projected.

The correct structure depends on the business plan.

A stabilized property intended for a ten-year hold may support highly structured long-term debt. A transitional property undergoing renovations or lease-up may require more flexibility, even if that flexibility comes with a higher initial interest rate.

The financing must fit the property and the business plan. The property should not be forced into the wrong financing simply because the rate looks attractive.

#4 - Prepayment and exit costs

Borrowers often compare the cost of entering a loan while giving insufficient attention to the cost of paying it off.

Potential exit costs include:

• Yield maintenance
• Defeasance
• Prepayment lockouts
• Minimum interest requirements
• Exit fees
• Extension fees
• Open prepayment windows

These provisions matter when an owner expects to sell, refinance, recapitalize or return investor capital before the stated loan maturity.

Consider a borrower that expects to sell within three years. A ten-year fixed-rate loan might offer a lower coupon, but a substantial prepayment penalty could eliminate much of the apparent savings, and interfere with the planned sale.

Your anticipated exit should influence your financing decision from the beginning.

#5 - Alignment with the business plan

Every financing comparison should ultimately return to the owner’s strategy.

Is the objective to:

• Hold a stabilized property for the long term
• Complete a renovation or repositioning
• Lease vacant space
• Maximize current cash flow
• Return capital to investors
• Sell within several years
• Preserve the ability to refinance

The optimal loan for one strategy may be entirely inappropriate for another.

The best financing is not necessarily the loan with the lowest coupon, highest proceeds or longest term. It is the structure that best supports the most probable business plan while protecting the owner if the plan takes longer or costs more than expected.

Inside the Deal

Consider this simplified example based on situations I have encountered during my career.

An owner is evaluating two refinancing proposals.

The first loan offers the lower interest rate, but it provides less proceeds, includes a restrictive prepayment structure and requires lender approval over several operational decisions.

The second loan carries a moderately higher interest rate. However, it requires less initial capital deployed at closing, provides greater operational flexibility and offers a practical path to prepayment if the property is sold.

Viewed only through the interest rate, the first proposal appears superior.

Viewed through the owner’s actual strategy, which includes completing improvements and potentially selling within several years, the second proposal may be the better economic choice.

The additional annual interest expense might be outweighed by:

• Less capital required at closing
• Greater control over the business plan
• Reduced exposure to prepayment penalties
• A higher probability of executing the planned sale

This does not mean the higher rate loan is always better either. It means the interest rate alone cannot answer the question.

The financing must be evaluated as part of the complete investment strategy.

The Guardrail

Never select a real estate loan by comparing interest rates alone.

Before choosing a proposal, answer these five questions:

1. How much total equity will the structure require?
2. What could prevent the lender from closing as proposed?
3. Which provisions could restrict the property’s business plan?
4. What will it cost to sell or refinance earlier than expected?
5. What happens if the plan requires 12 months longer than projected?

If those questions have not been answered, the proposals have not yet been fully compared.

What I’m Watching

I am paying particular attention to properties with loans maturing during the next 12 to 24 months.

Owners in this situation can benefit from beginning the financing conversation early.

An early review can help establish:

• The property’s supportable loan amount
• Likely valuation and underwriting issues
• Current lender appetite
• Potential equity requirements
• Steps that could improve financing options before maturity

Waiting until a loan is approaching maturity reduces negotiating leverage and increases the risk that the borrower must accept whatever capital is available.

Even if you do not intend to refinance immediately, understanding your likely options today can prevent an unwelcome surprise later.

The Bottom Line

1. Interest rate is only one component of the total cost of capital.
2. The loan structure must support the property’s actual business plan.
3. The best time to identify a financing problem is before the transaction becomes urgent.

A Question for You

Which loan provision has caused the greatest difficulty for one of your properties?

Reply and let me know. I plan to use the questions and experiences readers share to help shape future editions of The Guardrail Report.

A Request for You

If you have a commercial real estate loan maturing within the next 24 months and would like an independent assessment of the available options, you are also welcome to reply directly to this email.

Regards,

Robert Newstead
Guardrail Finance
Commercial Real Estate Capital Advisor and Investor

The Guardrail Report is provided for general educational and informational purposes. It is not investment, legal, tax or accounting advice, and it does not constitute an offer to sell or a solicitation to purchase any security.

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