Lenders’ latest lifeline for borrowers: pay and accrual loans   

Lenders are increasingly turning to a tried-and-true strategy that could give stable sponsors a lifeline in today’s market: pay and accrual loans.  

Also known as deferred payment loans, this structure allows a borrower to split interest payments into two parts with the aim of bridging short-term financing issues and paying lower up-front financing costs. 

“Deferral of payments has always happened, but more lenders are open to it now because rates are high and projects require some flexibility from the borrower and lender to get a deal done,” says Manish Shah, senior managing director at Austin, Texas-based manager Palladius Capital Management.  

The structure is another way in which borrowers are seeking to buy time when faced with near-term maturities in a higher interest rate environment, notes Dan Lisser, a senior director at New York-based advisory Marcus & Millichap Capital Corporation. 

The structure works like this: in a situation in which a borrower has obtained a loan with a 9 percent interest rate, the borrower will pay 6 percent now while the remainder would accrue and be repaid with the loan’s principal balance at maturity.  

“The lender is willing to be flexible to originate a loan in a time of a higher rate environment. [The structure] saves on current cashflow and from the lender’s point of view they understand the borrower has this current cashflow problem,” Lisser said. 

Analyzing cashflow 

When originating pay and accrue loans, a lender needs to carefully analyze a borrower’s cashflow to determine what they can reasonably pay, believes Brad Salzer, president at Tampa, Florida-based Redstone Funding. Without this analysis, the borrower might remain stretched, and the situation could devolve further.

These loans are also seen more in value-added, renovation or construction situations, which typically only generate cashflow once completed or sold. “[In this scenario] some lenders would insist on an interest reserve during that period to make up for the gap between what the property is generating and accrual,” Shah adds.  

Shah also cited multi-property developments such as an industrial park where it is possible to have two buildings generating cashflow and a similar number being renovated. 

“This is a very good example of where a partial accrual matching the business plan,” says Shah. “Half of the property is rented, half the property is being renovated – pay 5 percent current, accrue 5 percent and then when the property is fully renovated, congratulations – you can now support your 10 percent.” 

The multifamily sector, however, might be the best fit, reckons Toby Cobb, co-founder and managing partner of 3650 REIT. Many multifamily assets were often purchased at very low cap rates, making the ability for cashflow to cover the new interest rate a lower probability. “It makes sense in deals that have higher rent growth potential,” he adds. 

Everything old is new again 

While increasing in frequency, pay and accrue loans are nothing new.   

“It has just been popularized,” says John Confrey, audit and advisory partner of real estate services at global advisory firm Mazars. “What you are seeing, especially when you are coming up to maturity of loans, is that if you’re having cashflow problems, and you believe in your asset, a [pay and accrual loan] is a way to buy time.” 

Deferring payment is effectively compounding the interest and principal at the same time, Confrey adds. 

“Whereas typically, in a healthy market, you are refinancing, paying off a loan, taking up more proceeds and cashing out early, crystallizing the value that you’ve built up in your asset,” he says. “Now, you’re forced to hold on tight and see if you can make it work. It’s about betting on the market going up and rates coming down.”   

David Robinov, managing director at New York based Ackman-Ziff Real Estate Company, is of the mindset that this is not a preferred structure, even in a time of market distress. 

“I do not think anyone is looking to originate a loan right now is preferring to offer pay and accrue,” Robinov says. “If there are better sponsors and better assets, where you can get paid in full, why would I lend you money and say, ‘Pay 9 percent interest, but I know you only have 6 percent in your pocket right now, you are good for the other 3.’ If somebody else is out there that has the ability to pay, I’d rather lend you less, and you pay me the full amount of interest.”  

Robinov’s view is that this structure is most prevalent in the case of a refinancing. 

“The lender is only going to do this in the situation where they have an existing loan maturing, they have a solid underlying asset, they liked the borrower, and the math just doesn’t work to collect the full debt service on the full outstanding loan balance,” he adds. 

Ups and downs  

With pay and accrue loans, there are benefits and drawbacks. For the lender, it allows them to stay active in an uncertain environment, with the caveat of assuming more risk. 

“Their balance sheet is going to be exposed more from the buyer or the borrower side, so the risk is, ‘Can you get that yield out?’” says Confrey. “The time value of money becomes a race to the end.”  

The question becomes can a lender do this in a period that is short enough to get the capital out and the time value of money is not impacted. “Real estate is measured generally by [internal rate of returns]. So, maybe a month or two doesn’t matter. But it starts to matter when you’re talking about six months, a year,” he adds. 

There are additional risks, including the lender having to take a discount or complete a short sale if they want to exit the credit, adds Redstone’s Salzer. And another downside for the lender is the longer waiting period to have the loan repaid, Cobb says. 

“It is simply more debt on the asset. Instead of amortizing down, the maturity balance is growing. More debt equals more risk,” says Cobb. “In today’s world of less rent growth, the risk of less appreciation of the asset makes the accrual feature more risky.”  

While the structure buys a borrower time, the ultimate risk is that they might not be able to repay the loan. 

“When this pay and accrue loan comes due, [the borrowers] are now facing a very large, outstanding loan obligation because not only do they have the original loan balance, but they have 3 percent interest that has accrued and compounded,” says Robinov. “As a borrower, you have to believe that the net income will go up or that cap rates will go down. But if the value holds constant, the borrower is basically delaying but increasing the risk of foreclosure.”