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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   October 2008

Unconventional Deal? Avoid the Pitfalls

In today’s undercapitalized markets, brokers must be creative -- and cautious

c_2008-10_Arno_spotAlthough there has always been a need for creative financing, that need is now prominent. There are various types of financing that operate outside the norms of commercial real estate finance. To succeed in today’s markets, brokers must know the different kinds of creative financing available, as well as how to navigate the attendant risks of those options.

Sources of alternative financing

There are probably as many forms of creative financing as can be imagined. They offer the potential of an effective form of finance when conventional methods cannot.

Some common alternative sources for funding include:

  • Seller-financing, where the seller carries back part of the purchase price in a subordinate mortgage;
  • Installment purchases, where the purchase is paid over time -- usually, a few years -- which reduces the buyer’s initial capital requirement;
  • Purchase-money financing, which also includes private-mortgage financing, may involve hard-money rates and terms and private placement of equity to reduce the amount of debt required to acquire a property. This can mean the difference between borrowers qualifying or not for a new loan;
  • Participating debt, where the lender has a debt and equity position in the property; and
  • Wraparound mortgages, where the seller remains the obligor under an existing first mortgage and the buyer makes payments to the seller -- who in turn pays the mortgagee. These all-inclusive deeds of trust require disclosing the transaction to the existing lender, which must allow wrapping of the senior note. The absence of this could trigger acceleration pursuant to a due-on-sale provision, commonly found in senior-secured-debt instruments.

Still other alternative sources might be less common. These include:

  • Graduated payment versus balloon mortgages;
  • A cash-out refinance of another property to provide purchase money;
  • Establishing a sinking fund to provide lender evidence of how its note will be in part or wholly repaid;
  • Using a borrower’s securities portfolio as security for a loan to aid real estate purchases; and
  • Buying partnership interests equal to the amount of the seller’s equity and keeping the existing debt in the name of the partnership that owns the property. This is a form of wraparound financing in that the partnership continues to make the mortgage payments to the mortgagee.

Borrowers often have sources of capital they wouldn’t ordinarily consider. These include assuming a seller’s current financing, using a retirement plan to invest in a property or borrowing against cash values in life-insurance contracts.

Another interesting form of financing is contract manipulation. For example, a buyer ties up a property under an option to purchase. If the buyer needs a year to accumulate capital to complete the purchase, the price can be negotiated. This takes the property off the market until the buyer can perform.

All of these creative-financing options can help a broker’s clients find the funding they need. Each comes with its own risks, however, for the borrower and the broker.

Broker beware

When brokers recommend financing to a client that is not managed through conventional sources -- such as banks, credit unions and insurance companies -- they incur special potential risks.

These include the failure of the alternative financing to materialize, for which the borrower could hold the broker responsible. Moreover, exposure can arise from many aspects of the transaction involving its financing before the loan closes or even years after.

Here are a few rules to keep in mind.

1. Watch what you say and do: Take great care in discussing financing options with clients. Take time to meet with the clients and their accountant or preferably legal counsel. Creative financing often involves the use of specialized documents, which must comport with state law and serve to protect your clients’ best interests. Unless you are licensed to practice law, you cannot prepare these for your clients, and you cannot discuss their applicability as to their intended use in the transaction.

Creative financing can have material adverse financial, legal and tax consequences. When discussing alternative-financing methods, it’s imperative that you caveat your conversation with appropriate disclosures. Once you have completed your discussion, send your client a letter acknowledging that you met to discuss possible alternative-financing methods but that nothing you discussed was intended to be or can be construed as the giving of legal or tax advice. The letter also should address that your client must seek legal and tax counsel for a competent analysis of the risks and benefits possibly available through alternative financing.

2. Don’t participate in pennywise, pound-foolish actions: Some clients will ask you for a form to use in an alternative-financing transaction. It seems innocent enough. Fill in a few blanks, and you’ve managed to save your client some legal costs in document preparation. In most jurisdictions, however, you just broke the law. Merely providing a form for an intended use in a commercial transaction -- or assisting or advising your client how to complete or use the form -- can constitute the unauthorized practice of law. In addition, if the form ultimately is determined to be deficient, and your client incurs a financial loss or other liabilities as a result of using the form you provided, you may be sued.

3. Follow all federal and state securities laws: When private placement is used to purchase partnership interests, limited-liability-company-member interests or corporate securities to affect an interim form of alternative financing, these transactions constitute the sale of unregistered securities. Merely forming a business entity to raise capital as part of an alternative-financing scheme involves the sale of unregistered securities -- regardless of whether the securities offered are debt, equity or both. Although these can be excellent alternative forms of financing, federal and state laws involving securities transactions are complex. Violations of these laws can produce disastrous civil and criminal consequences. Financings of this nature should include advice from legal counsel versed in such matters. Also note: Only a licensed securities broker can offer the sale of the securities of an issuer. Unless you are licensed as a broker/dealer, you cannot lawfully offer or sell unregistered securities, regardless of whether you expected compensation.

The bottom line

Creative financing can be a deal-saver. It can produce financing-fee income and also can create prestige for you as a problem-solver. Handled correctly, with all requisite disclosures and managed under the guidance of tax and legal counsel, it’s a great tool.

Remember not to exceed your lawful authority and only to consider the use of alternative financing that serves the best interests of your client. This is a form of financing that requires assessment from you, your client and your client’s legal and tax counsel before moving ahead. 


 


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