Residual value insurance and net-leased investment properties

Real Estate Weekly, March 17, 1999 by William Reilly

Residual value insurance is an innovative product that is beginning to play a more significant role in the purchase, sale and financing of both net-leased and sale/leaseback real estate transactions. As time goes on, it may be a requirement of most lenders involved in these types of transactions.

The function of residual insurance is to indemnify the insured against a loss that might occur if the sale proceeds of a properly maintained building is less than the asset's insured reversion or residual value at the point specified in the insurance policy. It protects the lending institution against the risk of a decline in the market value of a financed asset. What the residual insurance policy does is guarantee to the lender a specific dollar amount for an asset at the termination of a lease or when the balloon payment on a mortgage is due. The benefits of residual insurance are that it protects against dramatic decreases in the value of an asset; protects the downside of the insured without decreasing the upside potential in the asset; and provides liquidity by converting asset value risk into credit risk.

The increase of securitization of commercial real estate loans and the way these loans are priced by the rating agencies have also given rise to increased demand by lending institutions for residual insurance. This insurance tool transforms an asset risk, which is the projected value of the building, into a known credit risk, with the credit risk being the credit of the insurance company that underwrites the policy, and the reversion value that they guarantee. This transformation of an asset risk into credit risk creates a larger pool of investors for the securitized transaction.

The largest risk in the real estate-based transactions is determining the value of the property at the end of a long-term lease, and the objective of the residual insurance is to upgrade a marginal credit net lease to bondable status for rating purposes and securitization.

To establish the residual value for the insurance company, valuations are secured which establish the re-rental or re-sale values of a property in a soft market at the termination of the proposed financing term or end of the lease. This guaranteed value is used by the lender to securitize the nonrecourse balloon portion of an acquisition loan on the asset. From the lenders perspective, an insured residual loan will not increase the loan-to-value ratio, but will create a higher rated loan asset for bank rating purposes, which translates into lower capital charges because the value of the insured asset is guaranteed by an investment grade insurer.

Residual insurance can create what is known as "synthetic equity" in an asset. The following example outlines the benefits that residual insurance may add in a real estate transaction. Assuming a $10 million self-liquidating mortgage amortized over a 10-year (120 payments) term at an interest rate of 7.25 percent, monthly payments would be $117,401. By guaranteeing the balloon payment, or residual value for $3 million, monthly payments would be reduced to $100,305, yielding a savings of $2,051,520 over the term of the loan. Assuming the same interest rate and loan term, but keeping monthly payments at $1 17,401 the loan amount could be increased from $10 million to $11,456,143, allowing the borrower to finance an additional $1,456,143. The cost of the residual value policy would generally run between 3 and 6 percent of the residual value, or in the above scenario between $90,000 and $180,000. The cost of the premium would be paid at the initial time of funding.

The CB Richard Ellis Tri-State investment Team has been involved in two recent sales where residual insurance played an instrumental part closing the transactions. We anticipate that this product will become more prevalent as Corporate America, especially those deemed less credit-worthy, will reallocate the equity that they have in their corporate real estate holdings into growing their core business units.

The first transaction involved the purchase of a building that was leased long-term to a tenant with substantial cash-flow but marginal credit due to significant debt it had taken on during expansion of the business. The other involved the sale/leaseback of a corporate headquarters facility where the corporate entity was able to raise capital, but at the same time keep the balance sheet in-line.

William Reilly, Senior Associate, CB Richards Ellis