Understanding commercial real estate finance and real estate investment trusts (REITs)

1. UNDERSTANDING COMMERCIAL REAL ESTATE FINANCE &
REAL ESTATE INVESTMENT TRUSTS (REIT)
Beth A. Di Santo, Esq.
Corporate Finance Partner

2. I. TRADITIONAL MORTGAGES
The following is a summary of the types of lenders by category:
The types of mortgages and related underwriting guidelines for residential and
commercial property are quite different. In its simplest terms, a mortgage is a method of
using real property as security for the repayment of debt. There are many variables to be
considered to determine the best financing product for your investment.
In general, there are three different types of loans on which banks lend:
-Construction: A construction loan is a temporary loan usually lasting six months to
a year that is used to complete a “to be built” project. Construction loans are paid off by a
long-term mortgage loan on the completed project. The proceeds from a construction
loan are disbursed in stages over the course of the project and the lender usually reviews
the project at various stages of the construction.
-Bridge: A bridge loan is a short-term loan that provides funds at the stage between
the construction phase and completion of the project (i.e., permanent financing stage).
Commercial bridge lenders may overlook property issues, incomplete permits, credit and
other problems in exchange for a higher rate of return. It is likely that lenders will look to
offset these risks by lending at a lower loan to value ratio, usually under 65% of the
property's value.
-Permanent: Permanent loans are generally loans with terms over three years. It is
common for lenders to convert construction loans to permanent loans upon completion of
construction. These loans are referred to as Construction-to-Permanent loans.
Commercial Mortgages and Real Estate Loans
Types of Commercial Property
The following is a breakdown of the various commercial property sectors. Each
sector faces its own set of issues that impact your ability to secure financing.
Multi-Family • Garden Apartments
• Hi-Rise Apartments
• Mid-Rise Apartments
• Low/Mod Income

3. • Student Apartments
• Senior Apartments
• Underlying Coop
Retail • Regional Enclosed
• Strip Center
• Outlet Mall
• Free Standing
• Single Tenant
• Regional Unenclosed
Office • Single Tenant
• Hi-Rise Tower
• Mid-Rise Office
• Office Over Retail Heavy
• Manufacturing
• Light Manufacturing
• Warehouse/Distribution
• Owner Occupied
• Multi-Tenant
• Self Storage
• Special Purpose
Health Care • Congregate Living
• Nursing Home
• Rehabilitation
• Ambulatory Care
Source: www.mortgage101.com
The Lender’s Perspective: Commercial Underwriting Guidelines
Underwriting standards and pricing of a loan is determined by the type of real
estate, tenancy, credit of the borrower and the institution or individual lending the funds.
In particular, the pricing is generally directly related to the risk associated with a
particular loan. Institutional lenders lend based on their cost of funds and access to
capital. When applying for a commercial loan, lenders typically evaluate certain criteria

4. to determine whether a particular loan will meet its underwriting guidelines. The
following is a brief summary of some of the most common underwriting guidelines:
Financial Analysis
The debt coverage ratio (“DCR”) is a crucial element to a lender’s evaluation of a
loan. The DCR is defined as the monthly debt compared to the net monthly income of the
property. Each lender has its own DCR policy and it’s important to understand what the
policy is before submitting an application. Most lenders will never go below a 1:1 ratio
(a dollar of debt payment per dollar of income generated) because anything less then a
1:1 ratio will result in a negative cash flow situation.
Loan to Value
Lenders typically view commercial investment properties more conservatively.
Lenders also look at the loan to value (“LTV”) ratio in evaluating an application. The
LTV is the percentage calculation of the loan amount divided by purchase price. It is
common for commercial lenders to require a larger upfront commitment from buyers
(i.e., a minimum cash payment of 20% by buyers). In commercial transactions, it is
imperative that the appraisal reflect the highest valuation for the property. This will
enable the buyer to receive more loan proceeds based on the LTV calculation.
Credit Worthiness
In general, commercial loans are held in the name of the business owning and/or
investing in the commercial property. If the business is less than three years old, it is
likely that the lender will require a personal guaranty from the principals of the company.
Further, lenders will rely on the credit history of the principals in evaluating a prospective
loan.
Property Analysis
In many instances, a commercial lender will conduct a fairly thorough analysis of
the fair market value of the subject property. Lenders will also analyze other
characteristics that may impact the value of a property (i.e., age, appearance, local
market, location, and accessibility).
Funding Needs Capital Source

5. -Acquisition and Development: Raw land infrastructure development (streets,
utilities, etc.)
-Adjustable Commercial Mortgage: Interest moves with a specific index (Prime, T-
Bills, etc.)
-Construction Mini-Perm: Construction with 3 to 5 year loan, usually on
income property.
-Construction Loan with Take-out: Construction with pre-arranged takeout loan in
place.
-Fixed Rate Commercial Mortgage: Interest Rate remains constant throughout the
term.
-Hard Money Loan: Loans from private lenders based primarily on
the hard asset value (commercial building,
vacant land, etc.).
-Interim Loan: A short term (2 yrs or less), bridge or project
type loan.
-Joint Venture: A financial partner in the development of real
estate.
-Participating Mortgage: Lender receives a kicker for gross income above
a preset level.
-Real Estate Sale and Leaseback: Lender purchases land and leases back to
borrower (generally developer) for a fixed rent
plus other considerations. Mortgages are issued
on leasehold at market rates. Usually, produces
more dollars than a mortgage.

6. -Real Estate Purchase Loan: Lending for the purchase of commercial real
estate.
-Second Mortgage(Commercial): Loan secured by equity behind that of the first
lien.
-Wraparound: Lender makes a second mortgage and assumes
the first mortgage.
The Borrower’s Perspective: Closing Commercial Loans
Commercial loans present a variety of legal and business issues that both borrowers
and their attorneys needs to recognize and negotiate. It is important for attorneys to
determine the legal issues that are important to their clients and the timeframe within
which the loan needs to close. Borrowers are mostly concerned with their liability under
the documents and the restrictions contained therein that relate to borrower’s ability to
operate their business. The following discussion addresses some of the more common
issues presented by commercial loans.
Prepayment Provisions
It is common for commercial loans (especially fixed rate loans) to include a
prepayment provision that limits a borrower’s ability to prepay all or part of the loan
prior to a date certain. . A prepayment penalty is a fee that is paid to the lender to
compensate it for the lost income it would have earned if the loan was not repaid prior to
the maturity date. It is imperative to address the prepayment terms so that the borrower
will have the flexibility to prepay the loan. Borrowers may with to prepay the loan if
they are able to refinance at lower interest rates or sell the property. The prepayment
provision should not be applicable in the event of certain involuntary prepayments (i.e.,
prepayment due to application of casualty process or condemnation).
Recourse
A recourse loan is a loan where the lender can look to both the collateral securing
the loan (i.e., the property) and the borrower in the event of default. A non-recourse loan

7. means that a lender can only look to the collateral to satisfy the loan obligations in the
event of default. It is common for a non-recourse loan to have a “bad-boy” provision that
allows the lender to look to the borrower if the borrower engages in certain bad acts.
These “bad-boy” provisions are essential carve-outs from the non-recourse aspects of a
loan that allow the lender to go after the borrower in the event of intentional acts by its
borrower. These certain circumstances include: environmental contamination,
misappropriation of funds, fraudulent misrepresentation, waste, and other types of serious
defaults. The loan documents should clearly limit liability to the appropriate parties. For
example, if the borrower is a partnership, the lender’s recourse should be limited to the
assets of the partnership and exclude recourse against the members of the partnership.
Further, the recourse provisions should be limited to actual damages incurred by a lender
rather than converting the loan to full recourse in the event of a violation.
In addition to the “bad-boy” provision, a bankruptcy or similar attempt to limit
lender’s ability to enforce/foreclose the lien against the property may also give the lender
recourse against the borrower.
Remedy and Default Provisions
The remedy provisions of the loan documents should be reviewed carefully to
ensure that the lender is not entitled to any extraordinary or inappropriate remedies. It is
difficult to negotiate remedies since these provisions are only effective in the event of a
borrower default. However, you can negotiate for appropriate grace periods and/or cure
periods to limit the events of default. Further, the events triggering a default should also
be negotiated to exclude circumstances outside the borrower’s control. For example, loss
of rental income due to tenant’s financial difficulties could cause a default on the debt
service coverage ratio. It may be possible to negotiate for a provision that would allow
the borrower to reduce the principal of the loan to remedy any debt service coverage ratio
defaults due to such loss of income.
Environmental Matters
Liability for environmental matters can be a major concern with commercial
properties, especially with respect to certain types of property. It is common for loan
documents to contain expansive representations, warranties and covenants from the
borrower regarding environmental matters. These provisions need to be carefully

8. reviewed and negotiated to limit borrower’s exposure. For example, the provisions
should exclude matters contained in existing environmental reports and include only
matters within the borrower’s actual knowledge. It is critical for the borrower and its
advisors to conduct a thorough due diligence investigation of a property to uncover any
potentially harmful conditions. The borrower’s representations should provide a basis for
liability only for matters that the borrower willfully withholds or omits.
Environmental indemnification provisions also need to be negotiated and limited
in time and scope. First, the loan documents should provide that the borrower’s liability
for environmental matters ceases upon a sale or transfer of the property. The lender may
seek to extend such liability after the borrower sells or refinances the property. It is
common for loan documents to provide an indemnification period through the statute of
limitations for the relevant environmental matter. Borrower’s should seek to have the
indemnification period limited to a date certain after closing because the statute of
limitations for certain environmental matters does not begin to toll until discovery of an
environmental condition.
Assignment of Leases
Lenders often seek to exercise control over the borrower’s lease arrangement with
its tenants because it is a major source of income that is used to repay the debt.
Borrower’s, however, need to maintain a certain level of control over its leasing
arrangements in order to effectively operate its business and maximize income. As such,
the borrower should attempt to limit the lenders control over its rental income and leasing
arrangements. It may be possible to create a “Form of Lease Agreement” that is
reviewed and approved by the lender at the loan closing that can be used for future
tenants. In the event that the lender does maintain some control over leasing decisions,
the loan documents should provide very clear terms and conditions and time limits for the
lender’s involvement.
Transfers
The loan documents will provide for restrictions on transfers of the property
and/or transfers of interests in the borrowing entity. The borrower should seek the
flexibility to transfer the property under certain limited circumstances. Further, the
ability to add or remove members or partners from the borrowing entity should also be

9. retained given that the borrower’s circumstances post-closing may change. It is likely
that the lender will require the managing member or general partner to remain obligated
under the loan documents. Transfer restrictions may be drafted so broadly as to include
put/call rights or rights of first offer that may be included in the operating agreements of
the borrower. If your investment is structured to include those sorts of rights, the transfer
provisions should be modified to specifically exclude those circumstances.
Borrower Entities
Lenders will often require that a borrower be formed as a single asset entity,
special purpose entity and securitized loans. This requirement is generally imposed to
limit the lender’s exposure to bankruptcy and default by isolating the collateral owned by
the borrower. If the entity is formed properly, affiliate entities of the borrower that
experience financial difficulties will not affect the subject property. The main
implication of these provisions for the borrower is the additional transaction cost of
forming and maintaining the new entity (for a purchase) or transferring the property (for a
refinance).
Lenders involved in securitized loans will require that the borrowing entity be a
“bankruptcy remote.” The loan documents will include several covenants that relate to
the maintenance of such an entity. Some of the common requirements are as follows:
• Maintain the borrower’s assets in a way which segregates and identifies such
assets separate and apart from the assets of any other person or entity;
• Hold itself out to the public as a separate legal entity distinct from any other
person or entity;
• Conduct business solely in its own name;
• Have no indebtedness other than a loan being made secured by a particular
property and indebtedness for trade payables incurred in the ordinary course of
business; and
• Have “independent directors” that must vote on matters involving the dissolution
or bankruptcy of the borrower and certain amendments to the borrower’s
organizational documents.
II. SECURITIZATION OF DEBT

10. What is Securitization of Debt?
Securitization of debt is a process by which identified pools of receivables, which are
usually
illiquid on their own, are transformed into marketable securities through suitable
repackaging of cash flows that such receivables generate. Essentially, securitization is a
credit arbitrage transaction that permits for more efficient management of risks by
isolating a specific pool of assets from the originator's balance sheet. Securitization is a
method of obtaining investment capital by selling interests in a pool of financial assets
(such as mortgage loans) to investors in the capital markets. The lenders are able to
diversity their investment and spread their risk of loss by pooling their funds and
investments together.
A traditional lender lends money to borrowers from its own balance sheet. With
securitization, the lender raises money in the capital markets to lend to borrowers. After
a loan is originated, the loan is pooled together with other loans, transfers it to an arranger
who then sells the income from such pool to investors in the form of securities in the
capital markets.
Parties to a Securitization
The following is an overview of the parties involved in a typical securitization:
-Originator—Owner and “generator” of the assets to be securitized (i.e., banks and other
financial institutions, governments and municipalities).
-Seller—Seller of the assets to be securitized.
-Purchaser/Issuer—A special purpose entity (SPE) that purchases the assets to be
securitized and funds the purchase price by issuing asset-backed securities into the capital
markets.
-Servicer—services the assets to be securitized and is responsible for collection,
administration and, if necessary, enforcement of the receivables;
-Investors—Purchasers of the asset-backed securities in the capital markets (i.e., pension
funds, banks, mutual funds, hedge funds, insurance companies, etc.).
-Lead Manager—Arranger of the transaction who is often the primary distributor of the
asset-backed securities in a particular transaction.

11. -Rating Agencies—Rate the asset-backed securities that are issued. The three key rating
agencies for securitizations are Standard & Poor’s, Moody’s and Fitch.
-Hedge Providers—Hedge any currency or interest rate exposures the Purchaser/Issuer
may have as a result of the securitization.
-Cash Administrator—Provides banking and cash administration services to the Issuer.
-Security Trustee—Acts as a trustee for the secured creditors of the Purchaser/Issuer.
-Note Trustee—Acts on behalf of the holders of the asset-backed securities.
-Auditors—if necessary they audit the asset pool as may be required under the
documentation of the relevant transaction.
Benefits of Securitization
The Lender/Originator’s Perspective
There are several reasons why lenders engage in securitized lending and the sale
of asset-backed securities:
-Access to Funds—Originators are able to raise funding in the form of the purchase price
to be paid by the SPE upon the sale and transfer of the securitized assets.
-Credit Exposure—Following securitization, the Originator’s credit exposure will be
limited to any credit enhancement it may provide.
-Improved Balance Sheet—A true sale securitization improves the Originator’s balance
sheet ratios to the extent that proceeds of the securitization are used to repay existing
liabilities, which may reduce the Originator’s leverage.
-Access to Funding Sources—Securitization allows the Originator to diversify its
funding sources away from banks in favor of the capital markets, without
having to issue securities on its own. Originators who already have established
direct access to the capital markets.
-Reduced funding costs. The weighted average cost of the securitization may be lower
than the cost of the Originator’s current bank or other debt. Notably, this is often the
case if the credit quality of the securitized assets is higher than the credit quality of
the Originator’s balance sheet as a whole.
The Investor’s Perspective
Investors in asset-backed securities can benefit in a number of ways, including the
following:

12. -Portfolio Optimization—Asset-backed securities provide a means for investors to invest
in asset classes and risk tranches of their choice and generate the associated returns.
-Reduced Volatility. Asset-backed securities have historically often been less volatile as
compared to corporate bonds.
-Favorable Yield Premium—Asset-backed securities have been known to offer a yield
premium over comparably rated government, bank and corporate bonds.
-Risk Diversification—Asset-backed securities are usually not susceptible to event risk or
the risk of a rating downgrade of a single borrower.
Issues with Securitized Loans
The purpose of a securitization transaction is to separate the borrower’s credit risk
from the leveraged asset. As a result, securitizing lenders deal with credit risk differently
than traditional lenders by structuring the loan and the borrowing entity in a way that
segregates the leveraged asset and requires higher impounds and reserves at closing. The
main issues with securitized loans are summarized below.
Credit Risk
In order to reduce credit risk, securitized lenders require that borrowers place the
collateral property in a special purpose vehicle (or SPV) thereby removing it from the
borrower’s balance sheet. The SPV is the borrower under the loan documents and is the
subject of several restrictive operational covenants. These requirements are intended to
isolate the property from other creditors and give the lender additional control of the
property after a default. In general, the rating agencies will ignore the credit risks related
to the borrower and look only the asset and immediate liabilities related to the property
itself. As a result, securitized loan documents focus more closely on property cash flow
and require stricter covenants on late rents and tenant vacancies and debt-service
coverage ratios. A traditional lender is generally more focused on borrower’s financial
status and loan-to-appraised value ratios.
Another method to reduce credit risk involves the use of impounds and reserves.
Rather than relying solely on borrower covenants, the securitized lender will require pre-
payments at closing of post-closing liabilities that could impact the collateral. SPV

13. borrowers will be required to fund reserve accounts for taxes, insurance and maintenance.
Lenders may also require additional insurance that would cover business interruption.
Credit Enhancement
A traditional lender may require credit enhancements if it determines that a
proposed loan has a high credit risk. Credit enhancements can take the form of additional
collateral, guarantees from creditworthy third parties, or cash reserves. On the other
hand, securitized lenders generally seek credit enhancements from the assets of the SPV
itself and cash reserves at closing. Third party credit enhancements are generally avoided
because this arrangement would require additional disclosure by the arranger in the
investor documents because the loan would not be in accordance with its uniform
standards. Additionally, rating agencies may lower their ratings which decrease the price
that investors are willing to pay for the asset-backed securities. However, several
originators and arrangers allow certain risks to be covered by a third party guaranty, such
as “bad boy” acts and environmental risks.
Restrictions on Junior Debt
Securitized lenders generally prohibit borrowers from incurring any junior debt.
In generally, the loan documents only permit the SPV borrower to incur the senior
securitized debt, liabilities to existing tenants under leases and trade debt incurred in the
ordinary course of business. These restrictions must be carefully considered while
negotiating the loan package.
Bankruptcy Remote Structures
Securitized lenders require that borrowers form an SPV to reduce the likelihood
that the borrower will become subject to a bankruptcy proceeding. In addition, lenders
generally require that a borrower adopt special charter and covenant provisions intended
to impair the borrower’s ability to file bankruptcy. This is called a “bankruptcy remote”
structure. BRVs also make certain covenants that are designed to maintain its corporate
identity separate from its parent, which reduces the risk that the BRV will be pulled into
the parent’s balance sheet in the parent’s bankruptcy proceeding. Lenders will also
require additional legal protection that is designed to assure the original contribution of
the property to the BRV was valid and not a fraudulent transfer.
Insurance Proceeds

14. All lenders require that borrowers maintain insurance coverage against the risks
of loss, usually with the lender listed as an additional insured in the loss payee clause of
such policy. The objectives of a securitized lender is different than that of a traditional
lender because they are interested in uninterrupted cash flow so that they can make
payments on the securities over a period of time. As a result, securitized lenders may
include a requirement that the insurance proceeds from a casualty be used to rebuild the
property rather than applying such proceeds to repay such loan.
Prepayment Provisions
Traditional lenders may permit prepayment of a loan without penalty, but this is
usually figured into the loan pricing. Some lenders will restrict a borrower’s ability to
prepay by limiting the time period, amount of prepayment and application of certain
prepayment fees. On the contrary, prepayments of securitized loans are always penalized
by a fee which may be characterized as a “yield maintenance fee,” “breakage fee” or
similar defeasance provision. The terms of the loan documents will penalize or mitigate
prepayments to assure predictability of repayment. The objective of these fees is to
compensate the lender for the “time-value-of money” as if the loan would have remained
outstanding until the scheduled maturity date. A defeasance provision is where the
original collateral is replaced by reliable financial instruments (such as Treasury
securities) that compensate the lender in the same way as the remaining debt service.
Defeasance is a method to maintain the original payment stream despite the fact that the
original asset has been removed.
Transfer Rights
Transfers of securitized loans are the norm. The objective of securitization is for
a lender to transfer a loan off of its balance sheet and into a securitized loan pool owned
by investors. In traditional loans, borrowers may seek to restrict the lenders right to
transfer a loan to maintain continuity of the business relationship with the lender. This is
not a realistic option with securitized lenders. Mortgage-backed securities are relatively
easy for an investor to evaluate as a result of the use of rating agencies, standardized loan
packages and summary disclosure documents.
Standardized Loan Packages

15. In packaging loans for securitization, arrangers require originators to use
standardized loan packages that have been developed for model disclosure and risk
analysis. The use of the standardized loan packages is critical to the reduction of
administrative costs that would otherwise be involved in evaluating unique loan
packages.
Pre-Pooling Analysis
Before loans are placed in a securitization pool, the loan packages are reviewed
for completeness and conformity to the pooling requirements. If there are deviations
from the pool requirements, a loan may be rejected by the arranger. A non-standardized
loan will not be acceptable because it renders the arranger’s uniform disclosure to
investors untrue with respect to that loan.
III. REAL ESTATE INVESTMENT TRUSTS
A real estate investment trust (or REIT) is a business entity that invests in real estate
directly, either through properties or mortgages. REITs are financial vehicles that allow
investors to pool funds for participation in real estate ownership or financing. Since
2001, REITs have been included in the Standard & Poor’s 500 Stock Index, the most
widely followed investment performance benchmark for U.S. equity markets. This
addition is evidence of the importance of commercial real estate in public capital markets.
REITs over time have demonstrated a historical track record providing a high level of
current income combined with long-term share price appreciation, inflation protection,
and prudent diversification for investors across the age and investment style spectrums.1
To qualify as a REIT, a company must distribute at least 90% of its taxable income to
its shareholders annually. A company that qualifies as a REIT is permitted to deduct
dividends paid to its shareholders from its corporate taxable income. As a result, most
REITs remit at least 100% of their taxable income to their shareholders and therefore owe
no corporate tax. Taxes are paid by shareholders on the dividends received and any
capital gains. Most states honor this federal treatment and also do not require REITs to
pay state income tax. Like other businesses, but unlike partnerships, a REIT cannot pass
any tax losses through to its investors. REITs receive special tax considerations, and
1
Investors Guide to Real Estate Investment Trusts, National Association of Real Estate Investment Trust.

16. typically offer investors high yields as well as a highly liquid method of investing in real
estate. There are three basis types of REITs:
• Equity REITs: Equity REITS invest in and own properties (thus responsible for
the equity or value of their real estate assets). Their revenues come principally
from their properties' rents.
• Mortgage REITs: Mortgage REITs deal in investment and ownership of property
mortgages. These REITs loan money for mortgages to owners of real estate, or
invest in (purchase) existing mortgages or mortgage backed securities. Their
revenues are generated primarily by the interest that they earn on the mortgage
loans.
• Hybrid REITs: Hybrid REITs combine the investment strategies of Equity REITs
and Mortgage REITs by investing in both properties and mortgages.
Dividends and Diversification
As discussed further below, REITs must pay out almost all of their taxable income to
shareholders. REITs can provide investors reliable and significant dividends (four times
higher than those of other stocks, on average). Analysis of historical data concluded that
the relatively low correlation between REITs and other stocks and bonds makes them a
powerful diversification tool.
Forming & Qualifying as a REIT
The following generally summarizes some of the basic tax law requirements applicable to
REITs. These rules are complex, and the following is only a general summary. In order to
qualify as a REIT, an entity must meet a number of organizational, operational,
distribution, and compliance requirements.
Organizational Requirements
A REIT must be formed in as an entity taxable for federal purposes as a corporation. It
must be governed by a board of directors or trustees, and its shares must be transferable.
Beginning with its second taxable year, a REIT must meet two ownership tests: it must
have at least 100 different shareholders (or the 100 Shareholder Test), and 5 or fewer
individuals cannot own more than 50% of the value of the REIT's stock during the last
half of its taxable year (or the 5/50 Test). These ownership requirements generally mean

17. that the REIT structure is not a good choice for a closely held family business. A number
of "look through" rules currently apply when determining whether the REIT meets the
5/50 Test.
In an attempt to ensure compliance with these tests, most REITs include percentage
ownership limitations in their organizational documents. For example, many REITs do
not permit any one shareholder to own more than at most 9.8% of a REIT's stock without
a waiver by the REIT's board of directors. Because of the need to have 100 shareholders
and the complexity of both of these tests, general legal, and tax and securities law advice
are strongly recommended prior to beginning the process of forming a REIT.
Operational Requirements
The REIT must satisfy two annual income tests and a number of quarterly asset tests that
are designed to ensure that the majority of the REIT's income and assets are derived from
real estate sources.
• Annually, at least 75% of the REIT's gross income must be from real
estate-related income such as rents from real property and interest on
obligations secured by mortgages on real property. Additionally, 95% of
the REIT's gross income must be from the above-listed sources, but can
also include other passive forms of income such as dividends and interest
from non-real estate sources (like bank deposit interest). As a result of
these rules, no more than 5% of a REIT's income can be from
nonqualifying sources, such as from service fees or a non-real estate
business. A REIT can own up to 100% of the stock of a "taxable REIT
subsidiary" ("TRS"), a corporation with which a REIT makes a joint
election that can earn such income.
• Quarterly, at least 75% of a REIT's assets must consist of real estate assets
such as real property or loans secured by real property. Although a REIT
can own up to 100% of a TRS, a REIT cannot own, directly or indirectly,
more than 10% of the voting securities of any corporation other than
another REIT, TRS or qualified REIT subsidiary ("QRS"), a wholly-
owned subsidiary of the REIT whose assets and income are considered

18. owned by the REIT for tax purposes. Nor can a REIT own stock in a
corporation (other than a REIT, TRS or QRS) the value of whose stock
comprises more than 5% of a REIT's assets. Finally, the value of the stock
of all of a REIT's TRSs cannot comprise more than 20% of the value of
the REIT's assets.
Distribution Requirements
In order to qualify as a REIT, generally, the REIT must distribute at least 90% of the
sum of its taxable income. To the extent that the REIT retains income, it must pay tax on
such income just like any other corporation.
Compliance Requirements
In order to qualify as a REIT, a company must make a REIT election. The REIT
election is made by filing an income tax return on Form 1120-REIT. Because this form is
not due until, at the earliest, March 15th following the end of the REIT's last tax year, the
REIT does not make its election until after the end of its first year (or part-year) as a
REIT. Nevertheless, if it desires to qualify as a REIT for that year, it must meet the
various REIT tests during that year (with the exception of the 100 Shareholder Test and
the 5/50 Test, both of which must be met beginning with the REIT's second taxable year.)
Additionally, the REIT annually must mail letters to its shareholders of record requesting
details of beneficial ownership of shares. Significant monetary penalties will apply to a
REIT that fails to mail these letters on a timely basis.
Advantages of REITs
Investing in real estate assets through the purchase of REIT shares provides certain
advantages not offer by alternative investments, including:
-Double taxation of distributions is avoided, thereby allowing more of the investor's
capital to compound.
-An experienced management team is responsible for the day-to-day operation of the
business, providing the investor with real estate industry expertise.
-Unlike real estate directly held by the investor, REITs are a liquid asset that can be
sold fairly quickly to raise cash or take advantage of other investment opportunities.

19. -Investors with are able to diversify their holdings between various geographic areas
and property specializations, which would not be financial feasible for most investors
through direct ownership of property.
-REITs have access to debt and equity markets to raise funds to take advantage of
opportunities when they arise.
-REITs have a lower correlation to equities than many other asset classes, providing
portfolio stability for those with an active asset allocation strategy.
-High cash dividends relative to the market tend to establish phantom bottoms to
REIT share prices, often keeping them from falling as far as common stock in bear
markets.
IV. CONSTRUCTION FINANCING
Construction financing is used to cover the variety of costs and expenses that are
incurred during the course of a construction project, including without limitation the
following:
Soft costs: Architectural, engineering, survey, construction permits, local taxes, utility
connection fees, and in general all the fees associated with the things that are done on
paper before the actual construction starts.
Hard costs: Actual cost of construction incurred from the moment the digging begins
all the way to laying the floor coverings and putting the landscaping and hardscaping
in.
Closing costs: All costs associated with closing the construction loan, including
origination fees, lender fees, title insurance, escrow or attorney fees, property
insurance, course of construction insurance, recording, funding and closing fees.
Land/Lot Value: The value of the land/lot to be built on or the structure that is being
improved. To determine the current land/lot value: (i) if the property is owned for
more than a year the fair market value is used or (ii) the purchase price is used if
owned for less than a year. If there is an existing property that will need to be

20. demolished, then the land/lot value may be the current fair market value of the total
property or the empty lot depending on the particular program’s guidelines.
Interest reserve: The interest reserve is determined by calculating 60 or 70% of the
simple interest on the total construction loan amount. This reserve will be used to
make the payments on the construction loan during construction. Interest is calculated
based on the actual amount borrowed at any one time and charged against the interest
reserve during construction.
Contingency reserve: A contingence reserve is always built into the budget to ensure
the timely completion of the project despite unforeseen price increases or cost over
runs. Contingency reserve is normally calculated at 5% of the total cost of
construction.
Inspection fees: Construction loans are reimbursement loans and as such, funds are
disbursed based on the work completed as verified by an inspector.
There are several ways to obtain financing for construction. Some of the more
common methods used by commercial developers are:
-Equity Financing—An investor provides funds for the construction in return for
equity in the business entity that is operating as the developer.
-Joint Ventures—An existing developer may enter into an agreement with a third
party individual or company to provide funds in exchange for a participation fee in the
profits realized from the construction project.
-Traditional Financing—A lender provides a loan for the construction (which is the
most common method and is discussed in detail below).
Types of Construction Loans
Constructions loans are generally structured to be temporary in nature and replaced
by permanent financing upon completion of the building project. There are two basic
types of construction loans:
-Construction-to-permanent loan: Generally, the borrower will only pay the loan
interest during the construction phase. After completion of the project, the loan converts
to a traditional mortgage where the borrower begins paying principal and interest. One of

21. the main advantages of this type of loan is that there is one loan application and one
closing. As such, borrowers are able to reduce the underwriting and closings costs
associated with two separate loans (i.e., mortgage taxes, title insurance fees, and other
closing costs). One disadvantage is that borrowers are not free to shop around for better
permanent financing at the completion of the project.
-Construction-only loan: This structure requires a separate loan for construction
purposes and a mortgage upon completion of the project. Only the interest is paid during
the term of the construction loan (usually short term) with the principal becoming due
when construction is complete. There are generally more closing costs with these types
of loans because there are two closings. However, borrowers are free to shop around for
permanent financing during the construction phase which may be advantageous
depending on market conditions.
Steps to Obtain a Construction Loan
Collateral: Many lenders will require the borrower to own the land before they can apply
for a construction loan. The lender will use the underlying land as its collateral for the
loan. Some lenders, however, will allow borrower to roll-up the land acquisition with the
construction financing.
Timing: Construction loans are generally short term loans with interest only payments
during the term and the principal becoming due at the end of the term.
Budgeting: It is critical to create an accurate budget for the entire project before applying
for the loan. As such, the borrower must obtain and evaluate any third party quotes
before creating the project budget. Lenders are averse to increasing amounts borrowed
after the construction has commenced.
Draws: Disbursements of the loan proceeds are called “draws.” The borrower will seek
to correspond the timing of the draws with payments of anticipated expenses in the
budget.
V. CONVERTIBLE DEBT

22. In addition to debt financing (i.e., mortgages) and equity financings (i.e., private
placements of securities), convertible debt is another financing alternative available to
real estate owners and investors. Convertible Debt is a loan (debt obligation) that can
convert to equity (stock ownership) under certain circumstances usually at some pre-
announced ratio. Convertible debt can take the form of corporate bonds, convertible
preferred stock, or mandatory convertible securities. Investors tend to like convertible
debt because they are in a “win-win situation”: if the borrower does well the investors
shares in the upside of the equity and if the borrower does poorly the investor is still
entitled to repayment of the debt obligation.
Although it typically has a low interest rate, the holder is compensated with the
ability to convert the debt to common stock, usually at a substantial premium to the
stock's market value. From the issuer's perspective, the key benefit of raising funds by
issuing convertible debt is a reduced cash interest payment. The primary disadvantage,
however, is that the value of shareholder's equity is reduced due to the dilution expected
when holders convert their debt into equity.
Raising Funds Using Convertible Debt
Convertible debt offerings are essentially securities offerings that can be made
publicly for listed companies or through private placements. It is critical to consult with
a securities law attorney before offering or issuing any convertible debt to ensure that you
are in compliance with all applicable federal and state securities laws. Issuers will need
fairly detailed disclosure documents (i.e., private placement memorandums, subscription
agreements, notes evidencing the debt and call provisions, etc.).