by Lucia Graziano O’Connell, Counsel, Real Estate Finance/Land Use, McGuireWoods LLP, T. Craig Harmon, Partner, Real Estate Finance/Land Use, McGuireWoods LLP, Paul J. McNamara, Associate, Real Estate Finance/Land Use, McGuireWoods LLP
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 single-borrower) 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 tried-and-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.
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.