In CTL transactions, the loan amount is largely determined by calculating the present value of the rent stream due during the primary term of the lease. Using this method ensures that the rents will be adequate to fully amortize the loan. However, if a balloon payment due at maturity is incorporated into the loan, an element of real estate risk is introduced into the transaction. This is because all the rents have been used for debt service, so if the value of the real estate is insufficient to cover the balloon, the loan is at risk of not being fully repaid.

Residual value insurance (RVI) guarantees to the lender that, if the asset is not of sufficient value to ensure the payment of the balloon, the final payment will be made by the insurer.

Why do borrowers want a loan with a balloon payment?

The addition of a final balloon principal payment at the end of the lease by a rated insurance company creates greater loan value than the present value of the lessee payments alone. By reducing the amount of rent that needs to be used to amortize debt during the primary term, cash flow to the borrower can be increased or, alternatively, additional debt can be serviced. This latter choice is what most often occurs in a CTL transaction with a balloon payment.

The RVI guarantee is essentially used to leverage up the amount of money that can be borrowed based on a given rent stream. The cost of the insurance is considerably less than the benefit of the additional loan proceeds, so it makes economic sense to use such an approach.

Underwriting Constraints

Typically, the maximum amount of RVI obtainable is 35% of today‚Äôs appraised value. However, this amount may be increased or reduced by factors such as the location of the asset, quality of the building, its age and its use. For example, a very specialized research facility would be difficult to insure since its value is mainly a function of its utility to the current tenant. In other words, the ability to “recycle” a property impacts on the amount of coverage available. As a rule of thumb, RVI for acceptable properties costs 5% of the balloon amount to be insured.

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