United States: Single Family Residential Portfolio Financing: The Pixilation Of Commercial Real Estate

Last Updated: February 18 2015
Article by Lucia Graziano O’Connell, Craig T. Harmon and Paul J. McNamara

A Balancing Act

By now, most in the industry will have heard of or had experience with the single-family rental (SFR) market, which typically involves a pool of single-family residential properties — usually at least several hundred and often several thousand of them spread across various states and localities within those states. Due to the size of the collateral pool, the asset class presents some unique challenges when it comes time to press the property into service as collateral. The typical commercial loan diligence standards and continuing arrangements during the loan term are not always practical or appropriate for SFR collateral. Financing SFRs calls for some unusual approaches on certain fundamental aspects of the mortgage loan process.

On the one hand, uncertainty with respect to a relatively untested asset class coupled with the necessarily limited diligence that can be performed on distinct assets of such scale tends to push lenders in the direction of higher standards/stricter requirements in some aspects of the loan arrangements. On the other hand, however, the diversification of some property risks that are inherent in the SFR collateral can wind up being the solution to some of the unique problems arising from the asset class. Balancing those pressures can be an interesting process, to say the least — especially as both sponsors and lenders wait to see how the investment community will ultimately view the asset class as it matures.

Financing the SFR Asset Class

Various favorable market conditions (including high inventory and attractive yields) have driven private investors to buy large portfolios of REO properties to rent. Recent estimates are that, within the past two years, some 200,000 single family homes have been acquired by owners with the intent to rent them, meaning institutional investors are the new landlords. Capital can be brought to bear in a number of ways; in fact, several institutional SFR owners are REITs, some have financed through single loan (or at least singleborrower) securitizations and certainly some SFR pools have been financed by portfolio lenders. Currently, loans are being closed on SFR portfolios with the intention of securitizing those loans in multi-borrower securitizations. It is there that the clash between the peculiar characteristics of this new asset class and the triedand- true customs of the mortgage industry becomes most stark. In general, the result has been to start with an approach that would be made in any multifamily property financing and, from there, to start shaving off square corners to prepare the things for round holes.

SFR Financing/ Diligence Challenges

An in-depth analysis of all challenges facing the legal team charged with completing an SFR financing is beyond the scope of this piece, but a few examples of issues that arise in the due diligence and documentation aspects of a transaction are instructive as they illustrate the types of matters that require approaches that differ from those customarily pursued in financings secured by other types of assets. As further discussed below, one overall safeguard will be that the owner/borrower will have the ability to release and potentially substitute one or more troubled properties (up to a certain extent).

Here are a few diligence issues that must be addressed:

Environmental Analysis. In traditional asset classes comprised of one or more multifamily, retail or office properties, a formal environmental report prepared by a reputable consultant is a fundamental component of due diligence; the significant liabilities that can attend environmental contamination and the costs and time associated with obtaining the report render the cost/benefit analysis an easy calculation. With SFR, however, the properties may be widely dispersed over numerous states, and even more counties and cities. Rarely would two or more properties even be located on the same street. A Phase I environmental assessment of the type normally expected in commercial real estate financings on each property in an SFR portfolio would simply be cost-prohibitive; a "desk" type review is the only sensible solution in most cases. Of course, an environmental problem with one home in a portfolio would not represent any indication of an issue within the remainder of the portfolio, so the lender has tremendous diversification of this risk to ameliorate the lack of certainty with respect to each individual property.

Property Reports. While required in connection with traditional CMBS and commercial loans, the volume of SFR properties in the collateral pool makes obtaining individual ALTA surveys, zoning reports and even evidence of compliance with local laws practically impossible. In some cases, the borrower/owner may have obtained pieces of the diligence such as surveys or zoning letters in connection with its purchase of the assets, but if not, the lender may end up limiting or eliminating the survey or zoning requirement altogether. Broker price opinions are very likely to replace traditional appraisals. Waiver of the requirements for these customary property-level materials may seem an anathema to the traditional mortgage lender (and its lawyers...), but the number and type of properties makes this a reasonable approach, with the lender looking again to the large number and diverse locations of the individual properties as a mitigation of risk.

Title. A title policy covering each property will surely be required, meaning title searches for hundreds of if not more than a thousand properties. Multiply the portfolio size by an assumed number of exceptions per property, and it is easy to see how time-consuming a standard review would be. Even assuming that a well-prepared commitment (or owner's policy) is produced for each property, and that only 1/3 of a 1000-asset portfolio has title documents of the type that would normally be carefully reviewed (if not abstracted) the time to complete this task could run over 1000 hours easily. Even with efficient timekeepers at reasonable hourly rates, the traditional approach would be cost prohibitive. Perhaps, if the lender becomes comfortable with the borrower's acquisition processes, it may simply "spot check" rather than fully review each title commitment. Or perhaps the parties agree on a protocol that allows large categories of typical exception documents to go un-reviewed altogether. Depending on the state, many of the typical commercial endorsements (land same as survey, PUD, access, subdivision and in some cases a comprehensive endorsement) are either not available for residential properties or are not available without a survey (which lender may have waived) or other title work (which simply may not have been done in the properties' former lives as owner-occupied houses).

Since getting at least some details of title (legal descriptions, for an obvious example) correct is ultimately essential to the lender, the process cannot be given too short a shrift; someone — whether it be a title insurer or agency, the lender's in-house team or outside counsel — must put into place an efficient process for assimilating and manipulating title data, whether that data comes from the borrower's owners' policies, directly from new searches or a combination of the two. Selection of the title company is critical to coordinate not only the title work but the final policy with limited endorsements the lender is willing to accept. Even more so than usual, the national title office will have to work closely with and appropriately manage the various local agents, whose input is critical when it comes to minimizing recording/transfer fees and, mortgage taxes, and the procedures required for recording mortgages whose collateral will include multi-state properties. Commercial real estate professionals and their legal counsel that have previously dealt little with residential real estate will find out quickly that there is a big difference in the procedures and standards that prevail in the commercial and the residential universes.

The few preceding examples demonstrate the inherent conflict between the residential nature of an SFR portfolio and the commercial nature of a CRE loan. The kinds of issues identified above arise in just about every aspect of property level due diligence in an SFR portfolio financing.

SRF Financing / Document Challenges

Similarly, though the CRE finance markets (the securitization market, in particular) will expect to see documentation in form and in substance similar to the customary CRE documentation, adjustments must be made here as well. A typical form of loan agreement (or mortgage, if that's where the substantive deal points are embodied) cannot be adapted for use in an SFR financing without some important changes.

Here are some examples:

Substitution and Release of Properties. While many commercial loan arrangements contain provisions allowing for the release of portions of the collateral, and some contemplate substitution of collateral (in more limited circumstances), these concepts can be fundamental components of a SFR financing. In contrast to a mortgage loan secured by more traditional collateral, there are several foreseeable circumstances in which the borrower or the lender (or both) may want to get certain assets out of the collateral package. It is not unusual to close an SFR portfolio loan with a portion of the properties not yet stabilized (renovations completed and leases in place), so any failure to achieve stabilization on an appreciable number of properties could, among other things, drag down the DSCR of the collateral as a whole or result in property condition circumstances that are not optimal. Any documentation should contain specific, streamlined and easily-implemented procedures for substitution and release. Yield maintenance or prepayment premium issues will of course be front-and-center in these discussions. Since bankruptcy-remote SPEs can be expected to be required as borrower entities, care must be taken to conform the representations and the "separateness" covenants in the loan documents (and in the constitutive documents of the borrower entity if applicable) to the realities of the circumstances. For instance, a borrower entity that may, in accordance with the loan documentation, acquire a new property in the future will want to make sure that it does not inadvertently breach a representation or a covenant by doing so.

Issues Related to Property Management. With hundreds to thousands of properties located across states and different localities within those states, borrower/owners will often need to contract with more than one property manager and will have to rely on those management companies even more so than with the more traditional single property asset. Although many aspects of multifamily arrangements can be brought to bear in the documentation for an SFR portfolio loan, there are significant differences. And although big national companies are certainly moving into the SFR space, companies managing SFR properties are less likely to be accustomed to practices traditionally used in CRE financings than are commercial management companies. This becomes evident as various arrangements involving the managers are put into place. The management agreements must of course be subordinated and made subject to termination by the lender. Lockbox arrangements are normally required, so owners may have to explain to property managers (who may be accustomed to simply deducting their fees "off the top" of receipts and passing the remainder along to the owner) why they now have to remit all receipts and wait for the waterfall to run its course. Creative solutions such as reserve, escrow or "slush fund" arrangements with property managers might be required.

Representations and Warranties. Representations and warranties can normally be made in much the same fashion as with more traditional collateral types. However, the same factors that limit due diligence investigations on the lender's part (and probably limited investigation on the borrower's part at the acquisition phase) must be considered here as well. A borrower is well-advised to employ qualifiers related to knowledge and materiality (and the lender should agree to this) on those property-level representations that are the subject of truncated due diligence.

Casualty and Condemnation. The granularity of the collateral is very much a factor in negotiating limits for casualty and condemnation thresholds – what amounts can be retained by the borrower and applied to restoration without participation by the lender, what amount triggers an election by the lender to apply proceeds to the repayment of the loan, etc. The thresholds may be better based on allocated loan amount for each property rather than the amount of the entire loan. In addition (even in cases of damage that is very significant with respect to a specific property, but is still small as compared to the loan amount), it may not be practical for the lender to require the usual draw process and related monitoring of the work as it progresses (i.e. title endorsements, contractor waivers etc.). Lenders can be expected to argue for low thresholds, on the basis that any specific casualty or condemnation event can be expected to affect only one property – and therefore a miniscule fraction of the collateral. Indeed, even a relatively low (as compared to other CRE financing arrangements) threshold as a percentage of loan amount should give the borrower ample latitude in addressing any casualty or condemnation event that is likely to occur.

Special Secondary Market

Considerations. Especially in view of the fact that this asset class is a newcomer to the multi-borrower securitization arena, lenders might want to hedge their bets by creating as many options as possible for secondary market transactions. For instance, foreseeing some resistance by investors to exposure to this asset class, lenders may bargain for the right to split the portfolio, or to "uncross" loans that are cross-collateralized and/or cross-defaulted when made. Some hazards exist here for borrowers. Any agreement to split loans in the future by creating new portfolios can carry significant costs such as transfer costs to newly formed entities, entity creation costs and "no substantive consolidation" opinions. In addition, carving up existing SFR portfolios can wreak havoc on LTV and DSCR ratios unless the property selection process for the new (smaller) portfolios is carefully considered. While a borrower will be sympathetic to the lender's desire for this kind of protection, the issues of cost allocation and effect upon portfolio performance would require thoughtful negotiations.

Going Forward

As the SFR asset class matures as a source of collateral for commercial real estate mortgage loans, as the investment community comes to understand it and get comfortable with it, and as borrowers and lenders in the space identify and deal with the challenges of the class, accepted practices and documentation will settle into place. Both business people and lawyers engaged in these transactions as that process unfolds will have the opportunity to shape those arrangements as they work with this unique class of collateral, which is simultaneously residential and commercial

Originally published in CRE Finance World, Winter 2015.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.