1)
What is meant by a participation loan? What does the lender participate in? Why would a lender want to make a participation loan? Why would an investor want to obtain a participation loan?
A participation loan is where in return for a lower stated interest rate on the loan, the lender participates in some way in the income or cash flow from the property. The lender’s rate of return depends, in part, on the
performance of the property. Participations are highly negotiable and there is no standard way of structuring them.A lender’s motivation for making a participation loan includes how risky the loan is perceived relative to a fixed interest rate loan. The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults). Additionally, the participation provides the lender with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an income property often increase as a result of inflation. To some extent this protects the lender’s real rate of return. An investor’s motivation is that the participation may be very little or zero for one or more years. This is because the loan is often structured so that the participation is based on income or cash flow above some specified break-even point. During this time period, the borrower will be paying less than would have been paid with a straight loan. This may be quite desirable for the investor since NOI may be lower during the first couple of years of ownership, especially on a new project that is not fully rented.
2)
What is meant by a sale-leaseback? Why would a building investor want to do a sale-leaseback of the land? What is the benefit to the party that purchases the land under a sale-leaseback?
When land is already owned and is then sold to an investor with a simultaneous agreement to lease the land
from the party it is sold to, this is called a sale-leaseback of the land. One motivation for the sale-leaseback of the land is that it is a way of obtaining 100 percent financing on the land. A second benefit is that lease payments are 100 percent tax deductible. With a mortgage, only the interest is tax deductible. The investor
may deduct the same depreciation charges whether or not the land is owned, since land cannot be depreciated. This results in the same depreciation for a smaller equity investment. The investor may have the option of purchasing the land back at the end of the lease if it is desirable to do so.
3)
True or False: A loan in which the lender receives part of the proceeds from the sale of the property is known as a convertible loan.
False. In a convertible loan the lender can convert their debt interests to equity interests at some time (they purchase equity interest by using the face value of the debt). It may be upon sale of the property, in which case, they could receive part of the proceeds from sale of the property. However, the above statement better
describes a participation loan (equity kicker).
4)
Why might an investor prefer a loan with a lower interest rate and a participation?
An investor’s motivation is that the participation may be very little or zero for one or more years. This is because the loan is often structured so that the participation is based on income or cash flow above some specified break-even point. During this time period, the borrower will be paying less than would have been
paid with a straight loan. This may be quite desirable for the investor since NOI may be lower during the first couple of years of ownership, especially on a new project that is not fully rented.
5)
How do you think participations affect the riskiness of a loan?
There is clearly some uncertainty associated with the receipt of a participation since it depends on the performance of the property. The lender does not participate in any losses and still receives some minimum interest rate (unless the borrower defaults). Additionally, the participation provides the lender with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an income
property often increase as a result of inflation. To some extent this protects the lender’s real rate of return.
