Hot new developments in real estate finance.

The following new developments in real estate finance will be of interest to lenders, owners, investors, brokers and other real estate professionals, as well as all persons involved in real estate financings:

Parties to financings involving foreign persons or entities may be liable (under the final IRS "conduit" financing regulations) for substantial withholding taxes relating to "back to back" loans (i.e., a lender makes a loan to an intermediate entity, which in turn makes a loan to the ultimate borrower), guarantees, and other deals involving foreigners.

However, U.S. income tax on loans by foreign lenders to U.S. persons can still be avoided under the "portfolio interest exemption. Alternatively, a foreign lender may also be able to avoid U.S. income tax if the "borrower" is not a U.S. person, even if U.S. real estate secures the loan. A further option would be to make the loan in a foreign jurisdiction subject to a tax treaty with little or no withholding tax on interest (subject to the treaty-shopping rules).

Standard release provisions can trigger huge additional taxes in securitizations. Instead of such release provisions, borrowers in securitizations may be offered a "defeasance" right (allowing the borrower to get a release of the mortgaged property by posting liquid security). However, "defeasance" is usually costly and cumbersome, and thus may make securitizations impractical for some borrowers.

Financial derivatives allow the lender and the borrower to receive or make completely different payments with respect to the same loan. For example, a lender can get a floating rate while the borrower has the security of paying a fixed rate. Derivatives, therefore, facilitate new types of deals that used to be impossible.

Lenders

The following items are of interest primarily to lenders:

Lenders can diversify credit risk, and earn fees without investing capital, by selling "credit derivatives." The purchaser of the "credit derivative" is customarily obligated to pay the amount of the loan to the seller upon a "credit" event, such as a default or bankruptcy by the borrower. The lender selling the "credit derivative" reduces its capital requirements for regulatory purposes, but maintains the loan on its books, as well as the relationship with its borrower. Therefore, a "credit derivative" can function like the sale of a loan participation with 100 percent financing to the purchaser.

Banks that sell 100 percent of their interests in loans need to comply with the 1997 regulatory bulletin mandating special provisions in participation agreements.

Lenders can protect themselves against the erosion of profits from inflation by using inflation-indexed notes (i.e., notes providing for a below-market interest rate, together with an additional return based on increases in the consumer price index or a similar index). Lenders should consider tax, regulatory and usury issues relating to such notes.

New environmental insurance is now available to protect lenders with respect to the risk that the mortgaged property may become contaminated, after the original loan closing, but before the time that the lender acquires the property at foreclosure.

EDS is trying to promote the "paperless" mortgage (i.e., the conversion of documents from "paper" to "electronic" formats, to the extent practicable, in connection with the origination of mortgage loans, from application until closing).

Initially, at least, EDS is focusing on residential loans, but the same system will ultimately be applied to commercial loans.

Automated underwriting systems now in current use can reduce the processing time for loan applications from 15-20 days to 34 minutes.

Lenders who use computer credit scoring systems need to be familiar with new ECOA restrictions on credit scoring systems. Lenders who will receive contingent interest need to reach agreements with their borrowers regarding repayment schedules. Otherwise, their borrowers will have the right, pursuant to 1996 IRS regulations, to determine when such lenders receive income.

Lenders with loans payable in foreign currency, or using LIBOR or another foreign index, may need to protect themselves against potential currency changes (such as the Euro).

Lenders' due diligence may need to extend beyond real estate records to many public offices, in certain cases, in order to uncover zoning, environmental and other restrictions that will be binding on such lenders and that may substantially reduce the value of the mortgaged property.

Loan servicers must be prepared, after the original loan closing, to make timely challenges to such governmental restrictions.

A new "flood insurance" notice must now be given (pursuant to a 1996 amendment) to borrowers, servicers and insurers in certain cases.

Owners and Investors

The following items are of interest primarily to owners and investors:

The prepayment of rent under a lease, and the sale of the property or a leasehold interests, may trigger re-characterization of the deal by the IRS as an "obligation-shifting" transaction.

Financings which are subordinated to returns to investors (for example, loans by a government agency to the developer of low-income housing) may be re-characterized as "equity," with surprising tax consequences.

Taxable gain from a workout may be deferred in certain cases if capital accounts are not restated.

The preceding developments are discussed in more detail in Boyd, Real Estate Financing, available from Law Journal Seminars-Press (800-888-8300, ext. 6000).