Prescriptive Easements: A Comprehensive Guide

Everyone enjoys a surprise now and then. That is, everyone except commercial real estate owners who just discovered their ability to use and develop their property has been severely limited without their consent. The neighbor claims it has the right to drive delivery trucks across the owner’s parking lot. Another neighbor asserts it has the right to drain treated effluent into a stream on the owner’s land. How did this happen?

Prescriptive easements were established.

A prescriptive easement is a property interest acquired through a party’s unauthorized use of another’s real property for a certain period of time. If that party can prove their use met the required elements discussed below, the easement grants the party a right to use a specific portion of the property for a specific use. Because a prescriptive easement is by definition established without the landowner’s consent, and because it can have a significant impact on the property’s value and marketability, its appearance can be a most unwelcome surprise.

This article briefly describes the history and rationale for prescriptive easements, and then outlines:

  • The elements necessary to create one
  • How buyers can identify prescriptive easements, including the role title insurance can play
  • Steps landowners can take to identify and quash potential easements
  • How they can be terminated
  • The legal action used to enforce or eliminate an easement, and
  • Limitations on uses under prescriptive easements

But first… a cautionary tale.

The Drive-Through Bank with Drive-Through Delivery Trucks

In 1971, the Felgenhauers purchased property in Paso Robles, CA to build and run a restaurant. Felgenhauer v. Soni, 121 Cal.App.4th 445 (2004). Immediately behind their property was a parking lot owned by and servicing a neighboring bank. And immediately behind that, a public alley. From 1974 until 1999, trucks entered the alley and then crossed over the bank’s lot to make deliveries to the rear of the restaurant. Although the Felgenhauers owned the property during this entire period, they leased the land at certain times to third parties who bought the restaurant business.

The Felgenhauers never asked for permission to use the lot, nor did they assert they had a right to the truck use.

In 1988, the bank manager told one of the restaurant operators that the bank was going to erect a fence to separate the two properties. The operator asked if the bank would install a gate so deliveries could continue across the lot, and the bank manager agreed.

Given that the bank never intended to grant an easement, and because no one had ever brought a legal action to enforce or terminate the right to use the lot, there was no easement of record.

In 1998, the bank property, including the parking lot, was sold. The new owners informed the Felgenhauers their delivery trucks could no longer use the lot, and the bank was going to cut off the restaurant’s access. The Felgenhauers brought a quiet title action asserting the prior deliver truck use, done continuously and uninterrupted, openly, adverse to the bank owner’s property interest, and for the required period of time, established they had created a prescriptive easement.

The court agreed.

It turned out the new bank owners had purchased real estate not only with drive-through banking services, but also with drive-through delivery truck service to the restaurant next store.

A Brief History of Prescriptive Easements

As described in Michael V. Hernandez’s article “Restating Implied, Prescriptive, and Statutory Easements,” courts have recognized the right to prescriptive easements for centuries. Before 1275, English common law allowed for a prescriptive use if it extended beyond “living memory” or to the Norman Conquest (1066). After 1275, pursuant to Parliament’s enactment of the Statute of Westminster, the requisite period became the “limit of English Memory,” meaning to the time of King Richard (1189). The English courts then once more modified the prescriptive period, requiring that the continuous use had existed during “living memory.”

This practice continued until the 17th century, at which point the courts replaced the living memory standard with a specific number of years. This change coincided with the court-created fiction of a “lost grant.” This fiction meant that where property was used for a specific period of time, such use was evidence that the user had once been granted a right for such use, but the grant had been lost. The initial period selected was 20 years, the time related to an ejectment action. While the fiction of the “lost grant” has largely been abandoned by U.S. courts, the right to an easement based on continuous and unauthorized use for a specific period of time remains.

Rationales for the Concept of Prescriptive Easements

It seems counter-intuitive that a court would give away a portion of an owner’s property rights without their consent, especially to a party that had acted adversely to the owner’s rights. As Professor Hernandez discussed, the various rationales for prescriptive rights appear at times illogical, and often in conflict with the reality of modern day real estate usage. Nonetheless, courts and commentators have proffered the following justifications:

  • Punish an Owner for “Sleeping” on Their Rights: Some courts have suggested that well-established land uses should be protected, and owners who sleep on their property rights (not paying attention to others who may be infringing upon them), should be punished by losing some of those rights.
  • Incent the Productivity of Property: Courts have argued that society benefits when a property is put to productive use. Where an owner doesn’t do so, the owner should give way to those who are. As Prof. Hernandez pointed out, however, there are instances where society benefits from unproductive land. As an example, he cites farms that are paid by the federal government to not operate.
  • Quieting Title Increases Certainty and Marketability: Some have opined that a process to determine if a use has met the prescriptive elements, and thus whether an easement exists, removes uncertainty about interests in the property. It is argued that increased certainty encourages market transactions, and gives lending institutions greater comfort when providing credit for these transactions.  However, given that a prescriptive easement is created when the requisite elements are met, and not when a court is asked to enforce the easement by legal action, the ability for a prescriptive easement to exist without being of-record actually promotes uncertainty.
  • Reducing Litigation: Some have suggested that if a specific legal right can be created through granting a prescriptive easement, then litigation relating to arguments over property uses that have existed for a long time should be reduced. Prof. Hernandez responds that the statutes authorizing prescriptive uses actually increase litigation because they provide the use becomes a right after a set period of time. This forces the owner to bring a lawsuit to challenge the easement before the period has run.

Elements Required to Establish a Prescriptive Easement

To establish a prescriptive easement one must prove that all the requisite elements have been met: that the use was (1) adverse (sometimes referred to as “hostile”), (2) actual, open and notorious, (3) continuous and uninterrupted, and (4) for the statutorily required period of time.


Adverse means the user is acting without the consent of the owner, and in conflict with the owner’s property interest. Typically, if a use would give rise to a trespass, then it would satisfy this element.

In the Felgenhauer case, the bank claimed that the adverse element was eliminated in 1988 when the then-manager agreed to put a gate in the dividing fence and allow the restaurant’s delivery trucks continued passage over the lot. An act cannot be adverse to a property owner if the owner has given consent. Why then didn’t this consent defeat the prescriptive easement? Because the court found the prescriptive period had been satisfied before 1988, and the easement had already been created. Naturally, an owner’s consent to a use that has already been perfected will not extinguish the right to use.

Actual, Open and Notorious

This requirement means that the party seeking the easement must have actually used the property, and that his use was visible enough to give the owner actual or constructive notice. Constructive notice is when a hypothetical reasonable landowner should have noticed the use.

In one California case, a party sought to establish a prescriptive easement allowing them to cross a neighbor’s property with their motorcycles. However, no one had ever seen a motorcycle on the property, and in fact, the party had hidden their motorcycles following crossings. The court held that such “clandestine” uses failed the open and notorious element, and would not support granting a prescriptive easement.

It should be noted that while a user must make actual use of the property, their use doesn’t have to be exclusive. Another’s use may not disqualify a claim for prescription. And, as shown by the Felgenhauer case, a prescriptive use will not be denied simply because the owner also uses the easement property (the bank had used its own parking lot).

Continuous and Uninterrupted

The party seeking to enforce an easement must establish they have used the property continuously for the statutory time period, but continuously does not mean constant. For example, an easement for a car crossing property may be established if the driver crosses the property only twice a day–on its way to and from work. Seasonal uses may even meet this standard, provided the uses regularly occur each “on” season.

Additionally, the use must not have been interrupted by the owner. Generally, if a party other than the owner interrupts the use, this will not defeat continuity.

Required Period of Time

The period required to establish a prescriptive easement varies by state. For example, it is five years in California, 10 years in New York, and 20 years in Wisconsin. While the use must exist for this period, through the doctrine of “tacking” it can be accomplished by combining the times that successor parties used the property. For example, where Andrew uses Zach’s property for 10 years, Andrew sells his property to Barbara, and Barbara continues the same unauthorized use for another 10 years, a 20-year prescriptive period has been met.

Impact of Prescriptive Easement

Property Interest: Right to Use, Not Ownership

If a prescriptive easement is established, it conveys only a right to use the property, and conveys no ownership interest. Title to the property is maintained as it was prior to the easement. In contrast, when real estate is acquired by adverse possession, actual ownership of the land is transferred.

Diminished Value of Burdened Property

The marketability and value of real estate can be significantly reduced as a result of an unanticipated easement. When a property owner works with utility companies and public bodies regarding utility and roadway easements, and even when working with neighboring landowners for access easements, the easements are located and limited in scope to allow for the owner’s anticipated use of the property. But when an easement is created without the input of the owner, its location and intensity can drastically impact an owner’s ability to develop or sell their property.

Consider the bank’s position following the enforcement of Felgenhauers’ prescriptive easement. Is the property more or less attractive to future buyers with a permanent easement for truck traffic across its lot?

Owner May Not Interfere With Easement Holder’s Rights

Once a prescriptive easement is established, the landowner cannot interfere with the easement holder’s use. Nonetheless, an owner may continue to use the land underlying the easement so long as its use doesn’t unreasonably prevent the holder from its own rightful use.

How CRE Buyers Can Protect Themselves Against Potential Prescriptive Easements

Because prescriptive easements, prior to being validated by a court, are unrecorded, their presence will not be revealed by a due diligence process that only reviews title documents. However, there are steps a buyer can take to lessen the chance an undisclosed prescriptive easement exists.

Physical Inspection of Property, Aerials, and Interviews

When performing a traditional physical inspection of structures, buyers may also consider walking the property with a surveyor, reviewing the property lines and located improvements to look for signs of use other than the owner’s (e.g., paths, tire tracks, structures not included on the survey). While common prescriptive easements relate to a party passing over property, they can also permit other uses such as a drainage pipe discharging treated effluent into a stream on another’s land. Given that uses may be visible at limited times, if possible, a buyer may make multiple inspections at different times on different days of the week.

A review of aerial photographs can be helpful with property that is not easily accessible, e.g., heavily forested parcels (Google Earth is one resource for aerials). The bird’s eye perspective can also help identify uses that are more readily seen from a distance (e.g., a path across property which is well-worn in certain areas and near invisible in others). Additionally, the buyer may interview neighboring landowners and tenants about their use of the property, and whether agreements exist between the seller and neighbor.

Title Insurance

Due to the unrecorded nature of many prescriptive easements, a title review will not help a buyer identify an easement. But, title insurance can transfer the risk of one from the buyer to the insurer. Under their general exceptions, American Land Title Association (“ALTA”) policies exclude coverage for “unrecorded easements and claims of easements.” However, a buyer may purchase an extended coverage policy to eliminate this exception, putting the onus on the title company to determine the risk of a prescriptive easement.

Additionally, if a buyer provides the title company with an acceptable survey, the buyer may secure a survey endorsement (also referred to as a “same as survey” endorsement), which provides that the insured land is the same as that shown on the survey. Accordingly, if it is later discovered that a prescriptive easement existed at the time the policy was issued, and the survey did not include the easement, the title company would be responsible for the omission.

How Owners Can Prevent Prescriptive Easements

As to Identified Users: Consent or Self-Help

If a landowner has identified the party using its property without consent, and if the use has not yet existed for the statutory period, the most effective way to end the threat is to simply give express and written consent to the user. If the owner consents, the “adverse” element is then lost and no prescriptive easement can be established. There are different ways an owner may accomplish this, but common practices include a revocable and non-transferable license or written agreement. Either should define the scope and location of the permitted use, state the permitted users, and explain how and when the permission can be revoked. While the licensed use may be permitted for a specific period of time, in order to protect against the use negatively impacting the ground’s value, sellers often require that the right terminates upon transfer of the seller’s property.

An owner may also consider using “self-help” methods to prevent the ripening of a prescriptive easement, such as posting “no trespass” signs, erecting fences to interrupt the use, or sending notices demanding that the use stop. However, there is a risk with these methods. If the use continues after the self-help measure, and the owner makes no further efforts to prevent it, the self-help act may then become evidence that the use was in fact adverse.

As to Unknown Users: Consent and Monitoring

When a landowner is not aware of any specific threat, but believes there is the potential for prescriptive use (e.g., undeveloped or rural real estate is susceptible to claims of easement because they often cannot be efficiently monitored), the owner may still attempt to issue a consent to unknown users. Such attempts include posting signs stating something to the effect of “Private property. Permission to cross, but may be revoked at any time.” An owner should determine whether the state in which the property sits has codified language for signs to defeat the adverse element.

If the owner is in a position to monitor its property, it may regularly make the same kinds of inspections suggested for a buyer’s due diligence review.

How to Terminate a Prescriptive Easement

Easements can be terminated through release, merger, condemnation or abandonment, and lost by adverse possession.

Release (Or Release Plus License)

The most straightforward way to eliminate a prescriptive easement is to buy it from the user, thereby releasing their rights to use. If they are unwilling to immediately release their rights (this may happen where immediate loss of the easement makes the present use of their property impossible), they may agree to a release in exchange for a license. The license would allow the use, but will expire at a future, specified time. If the easement has not been validated by a court’s judgment, this option can be especially attractive to the holder because the license specifies the permitted use and location, eliminating the risk that a court either denies the easement or limits it beyond what the user anticipated. Of course, the licensee also enjoys the compensation they negotiated and the litigation costs they avoided.


The doctrine of merger provides that when the property owning the easement (referred to as the “dominant estate”) and the property burdened by the easement (the “servient estate”) are merged into a single ownership, the easement is extinguished. Put simply, an owner can’t have an easement over his own land. As this method requires the landowner to purchase the dominant estate, it may not be a desirable or feasible alternative.


Only a public body may condemn property through its exercise of the power of eminent domain. However, condemnation may be available to terminate a prescriptive easement across real property where a statutory public-private partnership is in use. For example, in certain states, the power of eminent domain may be used to advance a tax increment financing (“TIF”) project.


To establish that an easement holder has abandoned its rights, and terminate the easement, an owner must show the holder’s intent to permanently cease its use of the easement, plus an affirmative act (or a failure to act) that evidences this intent. Non-use of the easement will not on its own support a finding of abandonment.

Adverse Possession

An owner may attempt to terminate a prescriptive easement by the same steps used to create it in the first place: meet the elements of prescriptive easement. This commonly begins with an owner using some form of “self-help” to prevent the use. Provided this act satisfies the requisite elements, the easement will terminate.

However, two risks make this an unattractive method. First, the elements must continue for the statutory period. If at any point during that period the user asserts their easement rights, the owner’s prescriptive period will be reset, and they’ll have to start the process all over again. Additionally, the holder may not just assert its rights, but where the owner’s “self-help” constitutes substantial interference with an easement, the holder may pursue an action against the landowner for a private nuisance.

What Happens to a Prescriptive Easement When Land is Sold? When Land is Leased?

An easement is a property right, and as such passes with the property. The dominant estate’s right to use the easement is passed to its new owner, and the servient estate’s obligation to not interfere with the use passes to its new owner.

In contrast, where a prescriptive easement was created during a lessee’s possession of the servient estate, the statutory clock for the potential easement will reset when the lease term ends. This happens because although the user’s actions were adverse to the lessee’s interest, they were not to the landlord’s, as it held only a reversionary interest during the lease term.

Quiet Title Action: How to Enforce or Challenge a Prescriptive Easement

In order to enforce or challenge a prescriptive easement, a party must bring a quiet title action. This lawsuit is brought in a court with jurisdiction over the property to determine ownership and other property rights.

However, the action is not necessary to establish the easement. As shown in the Felgenhauer case, the easement is perfected as soon as the elements of prescription are met. The quiet title action only validates the easement (and the judgment then becomes part of the property’s record).

Limitations on Permitted Uses of Prescriptive Easements

Use Cannot be Intensified

An easement holder is granted the use established by its action during the prescriptive period, and the type or scope of this use cannot be expanded or intensified. For example, the delivery truck use granted to Felgenhauer could not be expanded to allow for constant semi-truck traffic if the Felgenhauers replaced the restaurant with a distribution center. Subject to the limitation below, exceptions to this rule may occur where a natural evolution in a dominant property’s use requires a change to the easement use.

Use Can’t Prevent Owner from Meaningful Use of Its Land

Where a prescriptive easement denies the landowner any meaningful use of his property, courts will recognize that it has the same effect as taking ownership by adverse possession. In such cases, no such easement will be enforced. Accordingly, while a use may be modified to accommodate a natural evolution, it will not be permitted if doing so would effectively eliminate any meaningful use of the servient estate.


In this article we discussed prescriptive easements by outlining what they are as well as how to create, protect against, and also prevent them. As always, it’s best to consult with an experienced real estate attorney if this is an issue you are dealing with. Have you encountered a prescriptive easement? Does your due diligence process include a physical inspection? Let us know in the comments below!

What You Should Know About Equity Waterfall Models in Commercial Real Estate

Equity waterfall models in commercial real estate projects are one of the most difficult concepts to understand in all of real estate finance. Cash flow from a development or investment project can be split in a countless number of ways, which is part of the reason why real estate waterfall models can be so confusing. In this article we’ll take a deep dive into real estate waterfall distributions, dispel some common misconceptions, and then we’ll tie it all together with a step-by-step real estate waterfall example.

What are Investment Waterfall Distributions?

First of all, what exactly is a “waterfall” when it comes to cash flow distributions? An investment waterfall is a method of splitting profits among partners in a transaction that allows for profits to follow an uneven distribution. The waterfall structure can be thought of as a series of pools that fill up with cash flow and then once full, spill over all excess cash flow into additional pools.

This type of arrangement is beneficial because it allows equity investors to reward the operating partner with an extra, disproportionate share of returns. This extra share of returns is called the promote, which is used as a bonus to motivate the operating partner to exceed return expectations. Under a waterfall structure the operating partner will receive a higher share of profits if the project’s return is higher than expected, and a lower share of profits if the project’s return is lower than expected.

The Importance Of The Owner’s Agreement

With investment waterfalls, cash flows are distributed according to the owner’s agreement. Because there are so many variables when it comes to investment waterfall structures, it’s critically important to always read the owner’s agreement. The agreement will spell out in detail how profits will be split among partners. While there are some commonly used terms and components in investment waterfall structures, waterfall structures can and do vary widely. This means there is unfortunately no one size fits all solution and the only way to understand a specific waterfall structure is to read the agreement.

Common Real Estate Waterfall Model Components

Although waterfall structures vary widely, there are several commonly used waterfall model components. Before we dive into our step-by-step waterfall model example, let’s first take a look at some basic building blocks.

The Return Hurdle

The return hurdle is simply the rate return that must be achieved before moving on to the next hurdle. This is important to clearly define because the return hurdles (or tiers) are what trigger the disproportionate profit splits. Since the term “rate of return” can be defined many different ways, the return hurdle in a waterfall distribution structure can also be defined in many different ways. In practice, the the Internal Rate of Return (IRR) or the Equity Multiple are commonly used as return hurdles. The IRR is the percentage rate earned on each dollar invested for each period it is invested. The Equity Multiple is simply the sum of all equity invested plus all profits divided by the total equity invested, or [(Total Equity + Total Profits) / Total Equity].

Once the return hurdle has been defined the next logical question is, from what perspective will the return be measured? Since a project will have a sponsor and at least one other investor, the return can be calculated from several different perspectives. The return hurdle could be measured from the perspective of the project itself (which could include both the sponsor and the investor equity), the third-party investor equity only, or the sponsor equity only.

The Preferred Return

Another common component in equity waterfall models is the preferred return. What exactly is the preferred return? The preferred return, often just called the “pref”, is defined as a first claim on profits until a target return has been achieved. In other words, preferred investors in a project are first in line and will earn the preferred return before any other investors receive a distribution of profit.  Once this “preference” return hurdle has been met, then any excess profits are split as agreed.

A few key questions with the preferred return are:

  • Who gets the preferred return? Preferred investors could include all equity investors or only select equity investors.
  • Is the preferred return cumulative? This becomes relevant if there isn’t enough cash flow to pay out the preferred return in any given year. In waterfall models this preferred return can either be cumulative or non-cumulative. If the pref is cumulative then it will be added to the investment balance for the next period and accumulate until it’s eventually paid out.
  • Is the preferred return compounded? A preferred return can also be compounded or non-compounded. When the pref is cumulative a key question is, is this unpaid cash flow compounded at the preferred rate of return as it accumulates?
  • What is the compounding period? If the pref is compounded then it’s also important to know the compounding frequency. The compounding frequency could be annually, quarterly, monthly, daily, or even continuous.

The Lookback Provision

The lookback provision provides that the sponsor and investor “look back” at the end of the deal and if the investor doesn’t achieve a pre-determined rate of return, then the sponsor will be required to give up a portion of its already distributed profits in order to provide the investor with the pre-determined return.

The Catch Up Provision

The catch up provision provides that the investor gets 100% of all profit distributions until a pre-determined rate of return has been achieved. Then, after the investor achieves the required return, 100% of profits will go to the sponsor until the sponsor is “caught up.”

The catch up provision is essentially a variation on the lookback provision and seeks to achieve the same goal. The key difference is that with the lookback provision the investor has to go back to the sponsor at the end of the deal and ask the sponsor to write a check. With the catch up provision, the investor gets 100% of all profits until the required return is achieved and only then will the sponsor receive a distribution. Typically the sponsor prefers the lookback provision (since they get to utilize money even if they have to eventually give it back), while the investor prefers the catch up provision (since they get paid first and won’t have to ask the sponsor to make them whole at the end of the deal).

Again, the important thing to remember about waterfall structures is that there is no one sized fits all solution and these terms and conditions will all be spelled out in the owners agreement. With these basic building blocks in our toolkit, let’s next move on to a detailed, step-by-step example of a real estate waterfall model.

Multi-Tier Real Estate Investment Waterfall Calculation Example

Suppose we have a general partner and an outside investor who contribute a combined total of $1,000,000 into a project. The general partner invests 10%, or $100,000, and the outside investor contributes the remaining 90%, or $900,000. All equity investors (which includes both the general partner and the third party investor) receive a 10% annual preferred return on their invested capital. If distributions in any year fall below the preference level of 10%, then the deficiency will be carried over to the following years and compounded annually at the preferred rate of return. In other words, the pref is both cumulative and compounded.

After the 10% preferred return hurdle has been achieved, then all additional profits up to a 15% IRR will be allocated at a rate of 20% to the general partner and 80% to the equity investors. After a 15% IRR hurdle has been achieved, then all additional profits will be allocated at a rate of 40% to the general partner and 60% to the equity investors. All IRR hurdle calculations will be at the project level.

So, based on the above assumptions, we have a 3 tier waterfall model with all IRR hurdles measured at the project level. The first tier or hurdle is a 10% IRR, the second tier is a 15% IRR, and the 3rd tier is anything above a 15% IRR.

Now, let’s looks how how we actually calculate these waterfall distributions.  First let’s take a look at our project level cash flow before tax and equity contributions over the holding period:

Waterfall Distribution Project Cash Flows

The first line is simply our before tax cash flow calculation from a standard real estate proforma. As you can see, the calculated IRR for the entire project is 21.24%. Intuitively this tells us we will reach the third IRR hurdle since 21.24% is greater than our third waterfall hurdle of 15%. The next few lines show how much equity is contributed to the project by the sponsor and investor and when it is contributed. Since all of the equity for this project is required at the beginning, it is all shown at time period 0.

Here is a summary including percentage allocations of the total equity contributions to the project:

Waterfall Distribution Equity Split

As you can see, the sponsor provides 10% of the equity, or $100,000, and the third-party investor contributes 90% of the equity, or $900,000. Next, let’s take a look at a summary of our promote structure discussed above:

Waterfall Distribution Promote Structure

There are 3 tiers (or hurdles) in this promote structure. Profits are split pari passu up to a 10% IRR. After the 10% IRR is achieved, then profits will be split disproportionately. Profits above a 10% IRR up to a 15% IRR will be split 80% to the third-party investor and 20% to the sponsor. In other words, the sponsor gets an additional 10% of profits in addition to his 10% pro-rata share of profits. This additional 10% is the “promote”. Finally, all profits above a 15% IRR will be split 60% to the third-party investor and 40% to the sponsor. This means the sponsor is getting a 30% promote after the final 15% IRR hurdle is achieved.

So far all of our assumptions are pretty straight forward and easy to understand. We have a 90%/10% equity split between the third-party investor and the sponsor, and then we have a 3 tier promote structure.  Now we need a way to actually calculate the profit splits at each tier.

Real Estate Waterfall Model Tier 1

To calculate the profit splits at tier 1 we have to first determine the cash flows required to achieve a 10% IRR. Then, we’ll allocate these cash flows to the sponsor and the investor based on the agreed upon profit splits at this tier. Finally, we’ll calculate how much remaining cash is available from the project that can flow into the next waterfall tier.

This is where waterfall distribution models get complicated, so let’s take it step by step.

Real Estate Waterfall Model Hurdle

The table above has a lot of information, so as we work through it below remember that all we are doing is calculating what a 10% IRR (Tier 1) looks like. Then, once we figure out what cash flows are needed for a 10% IRR, we simply allocate those cash flows (or available cash flows) between the Sponsor and Investor based on our Tier 1 promote structure. Finally, after netting out our Tier 1 cash flows from our before tax cash flows for the project, we figure out how much cash flow is remaining for Tier 2. With this big picture in mind, let’s walk through each line item in the table above.

Year 0 is the beginning of the project and as you can see our beginning balance is $0. On the next line below, you can see our equity contributions at the beginning of the project total $1,000,000. Next is the Tier 1 Accrual line item. This is simply the amount that is owed to the equity investors based on the 10% IRR. In this case the calculation is just 10% times the beginning balance, which for Year 0 is $0 since there is no beginning balance.

The Accrual Distribution line item is next and this is what actually gets distributed in this tier. This may or may not equal the prior Accrual line item. This accrual distribution calculation takes the lesser of 1) the Beginning Balance, plus Equity Contributions, plus the Tier 1 Accrual line item, or 2) the project’s cash flow before tax. The reason why this is the lesser of these two items is because we are limited by the cash flow available from the project and can’t pay out more than this amount. Conversely, if there is more than enough cash flow from the project to pay out what’s owed to us, then we don’t want to pay out any more than this.

The Ending Balance line item takes the sum of the beginning balance, equity contributions, Tier 1 accrual, and Tier 1 distributions. This is simply taking what we start with (beginning balance), then adding in any new equity contributions, then accounting for the difference between what’s owed to us at this tier (the accrual) and what’s been payed out (the distribution).

In Year 1 we use the ending balance from the prior year (Year 0) as our Year 1 Beginning Balance. Then we simply repeat the process discussed above by calculating our Accrual based on the beginning balance for this period, then we calculate our actual distributions for this period, and finally our Ending Balance for this period. We continue this process for all years in the holding period and once completed we can then move on to splitting up cash flows between the Investor and the Sponsor in this tier.

The cash flow splits are shown on the three line items below the Ending Balance: Investor Cash Flow, Sponsor Equity Cash Flow, and Sponsor Promote Cash Flow. Investor cash flow is the percentage of Tier 1 distributions that flow to the investor and sponsor cash flow is divided into two components. First, the sponsor equity cash flow is the portion of Tier 1 distributions attributed to the sponsor’s pro-rata (10%) equity investment. Second, is the sponsor promote cash flow, which is the bonus cash flow that flows to the sponsor for achieving the IRR hurdle. In Tier 1 there is no promote, which means 90% of the Tier 1 distributions flows to the investor and 10% flows to the sponsor.

Real Estate Waterfall Model Tier 2

Now let’s take a look at the second IRR hurdle and repeat the same process we followed for Tier 1:

Real Estate Waterfall Model Hurdle 2

This table is exactly like the table used above for the first hurdle. The key difference is that this time we are calculating the cash flows required for a 15% IRR and then we are splitting them up between the investor and the sponsor at different rates. When calculating the cash flow splits we are also taking into account any distributions made in Tier 1. Let’s take a look at how this works.

In Year 0 we start off with $0, contribute $1,000,000 in equity, and since our beginning balance is $0 there aren’t any accruals nor any distributions. In Year 1 we start off with the $1,000,000 ending balance from Year 0, and our Year 1 accrual is 15%, which is $150,000. However, the project cash flow before tax is only $90,000, so there is a deficiency of $150,000 minus $90,000, or $60,000. This $60,000 deficiency gets added to our ending balance and carried over to the next year, where this process continues.

Once we’ve followed this process for all years in the holding period, we can then move on to calculate the cash flow splits between the investor and the sponsor. This is the same process we followed for Tier 1, except now the sponsor has a 10% promote. This is an additional 10% allocated to the sponsor above and beyond the sponsor’s 10% pro-rata share. Since we are allocating an additional 10% to the sponsor, this 10% is taken away from the investor’s original 90% allocation, which leaves the investor with 80% of the cash flow in Tier 2.

Besides including the promote in this Tier, the other difference here is that we are also netting out the cash flow taken in Tier 1. Since Tier 1 was calculated based on a 10% IRR, the Tier 2 15% IRR already includes the first 10%. In other words, the cash flow distributed in Tier 2 is only the incremental cash flow above 10% and up to 15%. To account for this we must subtract out any cash flow taken in prior tiers when calculating the cash flow for the current tier. This is why the cash flow is $0 for the first four years in the holding period (all of the cash flow was already distributed in Tier 1).

Real Estate Waterfall Model Tier 3

Finally, let’s take a look at the last hurdle, which is an IRR above 15%:

real estate waterfall model hurdle 3

This is the easiest to calculate since we don’t have to figure out the required cash flow for a particular IRR. Instead we simply take all remaining cash flow and allocate it according to the percentage splits at this tier. In this case the sponsor gets a 30% promote in addition to his original 10% share, which leaves the investor with 60% of the cash flow. Just like in Tier 2, all of the cash flow in years 1 through 4 is distributed in the prior tiers, which is why all the cash flows in Tier 3 are from the sale in Year 5.

Waterfall Model Returns Summary

The last component in our real estate waterfall model is to look at the total cash flows across all tiers for the investor and the sponsor and then finally we’ll calculate some overall return metrics.

real estate waterfall returns

In this table we are simply adding up the cash flows from each tier for both the investor and the sponsor. Then we calculate the overall IRR and equity multiple for both the investor and the sponsor. Recall from our project’s cash flow before tax that our project level IRR was 21.24%. However, based on our promote structure the sponsor earns a disproportionate share of these cash flows resulting in a 36.34% IRR for the sponsor and an 18.91% IRR for the investor. This disproportionate cash flow split is also reflected in the equity multiple, which is 1.98x for the investor and 3.85x for the sponsor.


In this article we tackled the real estate equity waterfall model, which is perhaps the most complicated topic in real estate financial modelling. The reason why real estate waterfall models are so complex is because there are so many variables that can be changed. We discussed some common components in equity waterfall models and emphasized the importance of reading the owner’s agreement in order to truly understand a waterfall structure. Finally, we walked through a detailed 3 Tier waterfall model example step-by-step.

How to Calculate The Debt Yield Ratio

The debt yield is becoming an increasingly important ratio in commercial real estate lending. Traditionally, lenders have used the loan to value ratio and the debt service coverage ratio to underwrite a commercial real estate loan. Now the debt yield is used by some lenders as an additional underwriting ratio. However, since it’s not widely used by all lenders it’s often misunderstood. In this article we’ll discuss the debt yield in detail and we’ll also walk through some relevant examples.

What is The Debt Yield?

First of all, what exactly is the debt yield? Debt yield is defined as a property’s net operating income divided by the total loan amount. Here’s the formula for debt yield:

debt yield

For example, if a property’s net operating income is $100,000 and the total loan amount is $1,000,000, then the debt yield would simply be $100,000 / $1,000,000, or 10%.

The debt yield equation can also be re-arranged to solve for the Loan Amount:

Debt yield loan amount formula

For example, if a lender’s required debt yield is 10% and a property’s net operating income is $100,000, then the total loan amount using this approach would be $1,000,000.

What The Debt Yield Means

The debt yield provides a measure of risk that is independent of the interest rate, amortization period, and market value. Lower debt yields indicate higher leverage and therefore higher risk. Conversely, higher debt yields indicate lower leverage and therefore lower risk. The debt yield is used to ensure a loan amount isn’t inflated due to low market cap rates, low interest rates, or high amortization periods. The debt yield is also used as a common metric to compare risk relative to other loans.

What’s a good debt yield? As always, this will depend on the property type, current economic conditions, strength of the tenants, strength of the guarantors, etc. However, according to the Comptroller’s Handbook for Commercial Real Estate, a recommended minimum acceptable debt yield is 10%.

Debt Yield vs Loan to Value Ratio

The debt service coverage ratio and the loan to value ratio are the traditional methods used in commercial real estate loan underwriting. However, the problem with using only these two ratios is that they are subject to manipulation. The debt yield on the other hand is a static measure that will not vary based on changing market valuations, interest rates and amortization periods.

The loan to value ratio is the total loan amount divided by the appraised value of the property. In this formula the total loan amount is not subject to variation, but the estimated market value is. This became apparent during the 2008 financial crises when valuations rapidly declined and distressed properties became difficult to value. Since market value is volatile and only an estimate, the loan to value ratio does not always provide an accurate measure of risk for a lender. Consider the following range of market values:

debt yield vs LTV

As you can see, the LTV ratio changes as the estimated market value changes (based on direct capitalization). While an appraisal may indicate a single probable market value, the reality is that the probable market value falls within a range and is also volatile over time. The above range indicates a market cap rate between 4.50% and 5.50%, which produces loan to value ratios between 71% and 86%. With such potential variation, it’s hard to get a static measure of risk for this loan. The debt yield can provide us with this static measure, no matter what the market value is. For the loan above, it’s simply $95,000 / $1,500,000, or 6.33%.

Debt Yield vs Debt Service Coverage Ratio

The debt service coverage ratio is the net operating income divided by annual debt service. While it may appear at that the total debt service is a static input into this formula, the DSCR can in fact also be manipulated. This can be done by simply lowering the interest rate used in the loan calculation and/or by changing the amortization period for the proposed loan. For example, if a requested loan amount doesn’t achieve a required 1.25x DSCR at a 20 year amortization, then a 25 year amortization could be used to increase the DSCR. This also increases the risk of the loan, but is not reflected in the DSCR or LTV. Consider the following:

debt yield vs amortization

As you can see the amortization period greatly affects whether the DSCR requirement can be achieved. Suppose that in order for our loan to be approved, it must achieve a 1.25x DSCR or higher. As you can see from the chart above, this can be accomplished with a 25 year amortization period, but going down to a 20 year amortization breaks the DSCR requirement.

Assuming we go with the 25 year amortization and approve the loan, is this a good bet? Since the debt yield isn’t impacted by the amortization period, it can provide us with an objective measure of risk for this loan with a single metric. In this case the debt yield is simply $90,000 / $1,000,000, or 9.00%. If our internal policy required a minimum 10% debt yield, then this loan would not likely be approved, even though we could achieve the required DSCR by changing the amortization period.

Just like the amortization period, the interest rate can also significantly change the debt service coverage ratio. Consider the following:

debt yield vs interest rate

As shown above, the DSCR at a 7% interest rate is only 1.05x. Assuming the lender was not willing to negotiate on amortization but was willing to negotiate on the interest rate, then the DSCR requirement could be improved by simply lowering the interest rate. At a 5% interest rate the DSCR dramatically improves to 1.24x.

This also works in reverse. In a low interest rate environment, abnormally low rates present future refinance risk if the rates return to a more normalized level at the end of the loan term. For example, suppose a short-term loan was originally approved at 5%, but at the end of a 3 year term rates were now up to 7%. As you can see this could present significant challenges when it comes to refinancing the debt. The debt yield can provide a static measure of risk that is independent of the interest rate. As shown above it’s still 9% for this loan.

Market valuation, amortization period, and interest rates are in part driven by market conditions. So, what happens when the market inflates values and banks begin competing on loan terms such as interest rate and amortization period? The loan request can still make it through underwriting, but will become much riskier if the market reverses course. The debt yield is a measure that doesn’t rely on any of these variables and therefore can provide a standardized measure of risk.

Using Debt Yield To Measure Relative Risk

Suppose we have two different loan requests, and both require a 1.20x DSCR and an 80% LTV. How do we know which one is riskier? Consider the following maximum loan analysis for both loans:

Debt Yield Comparison

As you can see both loans have identical structures with a 1.20x DSCR and an 80% LTV ratio, except the first loan has a lower cap rate and a lower interest rate. With all of the above variables it can be hard to quickly compare the risk between these two loans. However, by using the debt yield we can quickly get an objective measure of risk by only looking at NOI and the loan amount:

Debt Yield Comparison 2

As you can see the first loan has a lower debt yield and is therefore riskier according to this measure. Intuitively this makes sense because both loans have the same exact NOI, except the total loan amount for Loan 1 is $320,000 higher than Loan 2. In other words, for every dollar of loan proceeds, Loan 1 has just 7.6 cents of cash flow versus Loan 2 which has 10.04 cents of cash flow.

This means that there is a larger margin of safety with Loan 2, since it has higher cash flow for the same loan amount. Of course, underwriting and structuring a loan is much deeper than just a single ratio, and there are certainly other factors that the debt yield can’t take into account such as guarantor strength, supply and demand conditions, property condition, strength of tenants, etc. However, the debt yield is a useful ratio to understand and it’s being utilized by lenders more frequently since the financial crash in 2008.


The debt service coverage ratio and the loan to value ratio have traditionally been used (and will continue to be used) to underwrite commercial real estate loans. However, the debt yield can provide an additional measure of credit risk that isn’t dependent on the market value, amortization period, or interest rate. These three factors are critical inputs into the DSCR and LTV ratios but are subject to manipulation and volatility. The debt yield on the other hand uses net operating income and total loan amount, which provides a static measure of credit risk, regardless of the market value, amortization period, or interest rate. In this article we looked at the debt yield calculation, discussed how it compares to the DSCR and the LTV ratios, and finally looked at an example of how the debt yield can provide a relative measure of risk.

How to Calculate The Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio, usually abbreviated as DSCR or just DCR, is an important concept in real estate finance and commercial lending. It’s critical when underwriting commercial real estate and business loans, as well as tenant financials, and is a key part of determining the maximum loan amount. In this article we’ll take a deep dive into the debt service coverage ratio and walk through several examples along the way.

Debt Service Coverage Ratio Definition

First of all, what exactly is the debt service coverage ratio? The debt service coverage ratio (DSCR) is defined as net operating income divided by total debt service.

DSCR formula definition
For example, suppose Net Operating Income (NOI) is $120,000 per year and total debt service is $100,000 per year. In this case the debt service coverage ratio (DSCR) would simply be $120,000 / $100,000, which equals 1.20. It’s also common to see an “x” after the ratio. In this example it could be shown as “1.20x”, which indicates that NOI covers debt service 1.2 times.

What The DSCR Means

What does the debt service coverage ratio mean? A DSCR greater than 1.0 means there is sufficient cash flow to cover debt service. A DSCR below 1.0 indicates there is not enough cash flow to cover debt service. However, just because a DSCR of 1.0 is sufficient to cover debt service does not mean it’s all that’s required.

Typically a lender will require a debt service coverage ratio higher than 1.0x in order to provide a cushion in case something goes wrong. For example, if a 1.20x debt service coverage ratio was required, then this would create enough of a cushion so that NOI could decline by 16.7% and it would still be able to fully cover all debt service obligations.

What is the minimum or appropriate debt service coverage ratio? Unfortunately there is no one size fits all answer and the required DSCR will vary by bank, loan type, and by property type. However, typical DSCR requirements usually range from 1.20x-1.40x. In general, stronger, stabilized properties will fall on the lower end of this range, while riskier properties with shorter term leases or less credit worthy tenants will fall on the higher end of this range.

DSCR Commercial Real Estate Example

The DSCR is critical when sizing a commercial real estate loan. Let’s take a look at how the debt service coverage ratio is calculated for a commercial property. Suppose we have the following Proforma:

DSCR Proforma

As you can see, our first year’s NOI is $778,200 and total debt service is $633,558. This results in a year 1 debt service coverage ratio of 1.23x ($778,200/$633,558). And this is what the debt service coverage ratio calculation looks like for all years in the holding period:

DSCR calculations

As shown above the DSCR is 1.23x in year 1 and then steadily improves over the holding period to 1.28x in year 5. This is a simple calculation, and it quickly provides insight into how loan payments compare to cash flow for a property. However, sometimes this calculation can get more complex, especially when a lender makes adjustments to NOI, which is a common practice.

Adjustments to NOI When Calculating DSCR

The above example was fairly straightforward. But what happens with there are significant lender adjustments to Net Operating Income? For example, what if the lender decides to include reserves for replacement in the NOI calculation as well as a provision for a management fee? Since the lender is concerned with the ability of cash flow to cover debt service, these are two common adjustments banks will make to NOI.

Reserves are essentially savings for future capital expenditures. These capital expenditures are major repairs or replacements required to maintain the property over the long-term and will impact the ability of a borrower to service debt. Similarly, in the event of foreclosure, a professional management team will need to be paid out of the project’s NOI in order to continue operating the property. While an owner managed property might provide some savings to the owner, the lender will likely not consider these savings in the DSCR calculation.

Other expenses a lender will typically deduct from the NOI calculation include tenant improvement and leasing commissions, which are required to attract tenants and achieve full or market based occupancy.

Consider the following proforma, which is the original proforma we started with above, except with an adjusted NOI to account for all relevant expenses that could impact the property’s ability to service debt:

DSCR adjusted NOI

As you can see in the proforma above, we included reserves for replacement in the NOI calculation as well as a management fee. This reduced our year 1 NOI from $778,200 down to $728,660. What did this do to our year 1 DSCR? Now the debt service coverage ratio is $728,660 / $633,558, or 1.15x. This is much lower than what we calculated above and could reduce the maximum supportable loan amount or potentially kill the loan altogether. Here’s what the new DSCR looks like for all years in the holding period:

debt service coverage ratio calculations

Now when the debt service coverage ratio is calculated it shows a much different picture. As you can see, it’s important to take all of the property’s required expenses into account when calculating the DSCR, and this is also how banks will likely underwrite a commercial real estate loan.

How to Calculate The DSCR for a Business

The debt service coverage ratio is also helpful when analyzing business financial statements. This could come in handy when analyzing tenant financials, when securing a business loan, or when seeking financing for owner occupied commercial real estate.

How does the DSCR work for a business? The general concept of taking cash flow and dividing by debt service is the same. However, instead of looking at NOI for a commercial property, we need to substitute in some other measure of cash flow from the business available to pay debt obligations. But which definition of cash flow should be used? Given the importance of debt service coverage, there is surprisingly no universal definition used among banks and sometimes there is even disagreement within the same bank. This is why it’s important to clarify how cash flow will be calculated.

With that said, typically Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) or some form of adjusted EBITDA will be used. Common adjustments include adding back an appropriate capital expenditure amount required to replace fixed assets (which would offset the depreciation add back), and also taking into account working capital changes (to cover investments in receivables and inventory).

Let’s take an example of how to calculate the debt service coverage ratio for a business.

DSCR business

As shown above, EBITDA (cash flow) is $825,000 and total debt service is $800,000, which results in a debt service coverage ratio of 1.03x. This is found by dividing EBITDA of $825,000 by total debt service of $800,000. This gives us an indication of the company’s ability to pay its debt obligations.

If this analysis were for a tenant, we might want to subtract out existing lease payments and add in the new proposed lease payments. Or, if this were for an owner occupied commercial real estate loan, we would probably subtract out the existing lease payments and add in the proposed debt service on the new owner occupied real estate loan.

Based on the above 1.03x DSCR, it appears that this company can barely cover its debt service obligations with current cash flow. There could be other ways of calculating cash flow or other items to take into account, but strictly based on the above analysis it’s not likely this loan would be approved. However, sometimes looking at just the business alone doesn’t tell the whole story about cash flow and debt service coverage.

Global Debt Service Coverage (The Global DSCR)

Calculating the debt service coverage ratio like we did above doesn’t always tell the whole story. For example, this could be the case when the owner of a small business takes most of the profit out with an above market salary. In this case looking at both the business and the owner together will paint a more accurate picture of cash flow and also the debt service coverage ratio. Suppose this was the case with the company above. This is what a global cash flow analysis might look like if the owner was taking most of the business income as salary:


global DSCR

In the above analysis we included the business owner’s personal income and personal debt service. Assuming the owner was taking an abnormally high salary from the business, this would explain the low debt service coverage ratio when looking at the business alone as in the previous example. In this new global debt service coverage calculation we take this salary into account as cash flow, as well as all personal debt service and living expenses. Digging into how personal cash flow is calculated is beyond the scope of this article, but most of this information can be found just from personal tax returns, the personal financial statement, and the credit report, all of which will be required by a lender when underwriting a loan.

As you can see, this new global DSCR paints a much different picture. Now global income is $1,575,000 and global debt service is $1,100,000, which results in a global DSCR of 1.43x. This is found by simply dividing global income by global debt service ($1,575,000/$1,100,000). More often than not, a global cash flow analysis like this tells the full story for many small businesses.


In this article we discussed the debt service coverage ratio, often abbreviated as just DSCR. The debt service coverage ratio is a critical concept to understand when it comes to underwriting commercial real estate and business loans, analyzing tenant financials, and when seeking financing for owner occupied commercial real estate. We covered the definition of the debt service coverage ratio, what it means, and we also covered several commercial real estate and business examples for calculating the debt service coverage ratio. While the DSCR is a simple calculation it’s often misunderstood and it can be adjusted or modified in various ways. This article walked through the debt service coverage ratio step by step to clarify these calculations.

Demystifying Pari Passu in Commercial Real Estate

Pari Passu is Latin for “on equal footing”. In the world of finance it refers to a situations where two or more classes of people or transactions are managed without preference. Assets, obligations, securities, investors, and creditors can all be managed with a pari passu structure. One classic example of pari passu is the way unsecured creditors are treated in a bankruptcy. All the unsecured creditors get paid at the same time and the same fractional rate of the debt they were owed. In commercial real estate the pari passu structure is often used in commercial mortgage backed securities (CMBS) or in the waterfall structure of commercial real estate partnerships. In this article we’ll discuss pari passu in commercial real estate and clarify with some relevant examples.

Difference Between Pari Passu and Pro Rata

First of all, let’s tackle a commonly asked question about pari passu. What’s the difference between pari passu and pro rata? The terms pari passu and pro rata are often confused with each other. Pari passu is used to refer to a class. The debts or bonds are held pari passu. Pro rata technically refers to how something is distributed. In the bankruptcy example above, the unsecured debts are all pari passu. They are of the same class and will be paid on the same priority and without preference. Because the debts are pari passu, they must be paid pro rata. Distributing the money otherwise would give priority to some of the unsecured debt over others. In a practical sense there is little difference between pari passu and pro rata because when anything is held pari passu, the only way to preserve the “equal footing” is to distribute profits or losses pro rata.

Pari Passu in Waterfall Structures of Commercial Real Estate Partnerships

Pari passu is often used as part of a waterfall structure in a commercial real estate partnership. In its simplest form, some portion of the cash flow from an investment is distributed to all the pari passu investors or partners at the same time. There are usually certain targets that trigger the distribution of the cash flow. There are also usually one or more hurdles that, when cleared, allow for the managing partner to get paid an extra share of the cash flow. This is typically called the “promote”.

How does pari passu work in a waterfall structure? While waterfall structures can vary widely, it’s common to have all cash flow “pari passu” up to a preferred rate of return, say 8%. That is, up to 8% all cash flows are distributed in proportion to the investment amount (in other words, pro rata) to both the investor and the sponsor. Then, to provide the sponsor an incentive to achieve higher returns, certain tiers or return hurdles are set where (if met), the sponsor receives a larger disproportionate share of cash flow. These hurdles essentially break the pari passu structure and create increasingly disproportionate splits of the cash flow at each hurdle.

Understanding Pari Passu Structure in CMBS

Investors like pari passu structures because they allow risk to be widely allocated. Everyone is going to get paid at the same time. This reduces the risk of a project suddenly failing after some investors have been paid and leaving the remaining investors to bear the full brunt of the loss.

In CMBS a large loan on a single commercial property or project is split up into several smaller pari passu notes and those notes are packaged into different CMBS offerings. While not all the notes will be of equal size, all the pari passu notes will have the same payment priority.

These smaller notes are easier to sell as part of a CMBS because a buyer knows that a given project will only represent a small portion of the overall pool. Before the widespread adoption of pari passu structures by CMBS industry a single project might have been 20% of the pool in a single CMBS bundle. Now, usually the biggest notes are only 5% of the total pool.

Here is how a large commercial loan might be broken up in pari passu pieces and placed into a series of CMBS. The commercial loan will typically by made up of a primary note, sometimes called an A-note, and a subordinate note, sometimes called a B-note. The A-note will be split up into several different pari passu pieces and placed into different CMBS. Typically private parties hold B-notes instead of them being placed into a CMBS.

A single CMBS will be made up of several pari passu pieces of several different A-notes from many different commercial deals. The owners of the CMBS then own small pieces of the primary A-note from many different commercial loans. All of the loans that go into a CMBS are rated by a rating agency. Loans that have a low risk of default are given an “A” rating. Riskier loans are given some type of “B” rating. These ratings only relate to the risk of default and having nothing in common with the A-note and B-note designations from the original loan.

The first investors who buy the CMBS are called A-piece investors, because they are buying on the strength of the A-rated loans bundled in the CMBS. These investors will get paid first, but at a lower interest rate.

However, it is the second group of investors, the B-piece investors, which really control the CMBS market. B-piece investors have a subordinate interest to the earlier investors, but get a higher interest rate. They are buying the CMBS based on the rate of return of the B-rated loans. If a loan defaults or there is some other payment problem, all of the A-piece investors will get paid before any B-piece investor is paid. There are always buyers for the A-rated loans. But, if no one is interested in buying the B-rated loans, the CMBS system and market would collapse. CMBS are usually organized to appeal to the B-piece investors.

History of Pari Passu and CMBS

The idea of pari passu notes has been around a long time. CMBS have also been around for a long time. However, it was only after the events of September 11, 2001 that pari passu took on such a pivotal role in CMBS.

The loans for the World Trade Center were split into two different CMBS. While all bond holders were fully compensated after a period of time, the market became skittish of large commercial loans. The possibility of a single large default was suddenly seen as too big of a risk.

Pari passu solved this problem by spreading the risk of a single default across many different CMBS. No single investor or group of investors would bear a significant amount of the risk for a single loan. The use of pari passu for loans on large projects means that the holdings of a single CMBS are more diverse and therefore more stable.

Benefits of Pari Passu

The commercial real estate loan market has come to depend on pari passu. Lenders want to bundle up loans and sell them as quickly as possible to improve their cash flow and allow them to make additional loans quickly. Placing loans, or pieces of loans, into a CMBS improves the lenders capital position.

However, investors, especially the all important B-piece investors, are no longer willing to buy a CMBS where one note is a significant portion of the security. The only practical way to split up the large loans into different CMBS is to use the pari passu structure. Pari passu improves the liquidity of the entire system.

It allows investors to buy CMBS with confidence that the risk of default is low, it allows lenders to make more loans, and it allow developers to continue to pursue large commercial real estate projects. Virtually all of the growth in the CMBS market since September 11th is due in part to the pari passu structure.

Problems with Pari Passu

However, pari passu is not without its critics. Credit ratings agencies have voiced concerns for years that pari passu notes make workouts more difficult and time consuming. One of the problems during the housing meltdown and the Great Recession was that the home mortgages were split up into too many pieces and it took too long for loan workouts to take place. The longer it takes for a workout to be completed, the greater the losses end up being.

Credit rating agencies worry that the longer a note is on the market the harder it will be to track down all of the pari passu owners. Not only is it time consuming to track down all the stake holders in the case of a loan workout, but also the more stake holders the harder it is to reach a consensus. All of the delays could lead to a default that is not in anyone’s interest. Too many defaults and the CMBS industry could crash similarly to the way the home mortgage industry suffered in the Great Recession.

Pari passu notes add an extra layer of complexity to what is already a complex financial instrument. CMBS investors may feel more secure with the risk of default on a single loan more diffuse, but some critics worry the complexity increases the risk of systemic risks spreading through the system more quickly.

For now the overall default rate in the CMBS sector is well below 1%. The industry has seen the number of B-piece investors grow and shrink over the past decade and a half, but the market has always fond enough B-piece investors to keep the commercial loan to CMBS pipeline flowing.

Proposed Solutions to Pari Passu Concerns

Even though the CMBS market is largely seen as healthy and stable, there are two main things that could lower the potential risks posed by pari passu structures in CMBS. The first proposal would change who has authority to agree to a workout. The idea is that if the greatest risk is simply the large number of people that have to agree to a workout, shrink the number of people who have authority to agree to the workout.

This could be done in several ways. The B-piece investors could be given the sole authority to agree to a workout. The idea would be the first B-piece investor in the first trust where a pari passu note is placed is given the opportunity to take control of the B-note. If the first B-piece investor declined, the next B-piece investor would have the same opportunity. However, at least one B-piece investor would have to take control of the B-note and the authority to agree to a workout.

Another way to limit the risk of pari passu is to limit the transferability of shares. This would make it easier to know who needs to be consulted in the event of a loan workout. It would also mean that some later buyers would only get limited shares. They would not get workout authority with their shares. This idea is based on the way the syndicated loan structure has evolved.

Even with its critics, pari passu will remain integral to the CMBS industry for the foreseeable future. Investors are enthusiastic about it and large commercial real estate lenders see it an indispensable to keeping their business running smoothly.

Understanding Ingress and Egress in Real Estate

When property is purchased, buyers often make several assumptions. Buyers assume they will be able to use the property. Buyers also assume they can enter and exit the property. But, the rights to enter and exit the property may be separate from the ownership of the property. Ingress is defined as the right to enter the property and egress is defined as the right to exit the property. Others may also need or have a right to ingress or egress on your property. If proper care is not taken to understand and secure these rights, it could spell disaster for a commercial real estate transaction.

Ingress, Egress and Easements

The rights of ingress and egress are often secured by easements. An easement is a legal right to a limited use of another’s property. You may need an access easement to cross over someone else’s property to enter or exit your own property. You may need an easement on a private road that will allow you access to the property and ensure you can get to the main roads in the area. If there is a shared driveway, you may need an easement to allow you to use it.

Easements should be officially recorded, just as you would officially record the title to a property. Usually, you have the ability to sell an easement along with the deed to the property.

Others may have an easement on your property that gives them a right of ingress and egress as well. One typical example is the easement utility companies have on most properties. This easement allows them to enter a property to check meters and to repair or replace equipment essential to the working of the line. It is often not necessary for you to grant the easement to the utility company because in most jurisdictions the utility easement exists as a matter of law.

Special Issues of Landlocked Property

Some parcels of property are landlocked. They have no public access point. Landlocked parcels can be found anywhere. In a rural area where a large landowner is subdividing his or her land into smaller parcels, some of the parcels may be landlocked. In urban and suburban settings it is not uncommon to find a small store or other commercial enterprise surrounded by other businesses. The small store may be landlocked by its neighbors.

If a landlocked property does not already have an easement over adjacent property, you will need to secure an easement, or some other right of ingress and egress before buying the property. Otherwise you risk committing a civil trespassing offence every time you enter or leave your own property.

Landlocked commercial property in many jurisdictions does not come with an automatic access easement over neighboring properties. Lenders will require proof of the right of ingress and egress as part of the conditions of issuing a loan for the purchase of commercial real estate.

Neighboring landowners can sell an access easement. Sometimes neighboring landowners will want to limit the access an easement gives the landlocked property owner. However, easements are usually not a good way to strictly limit access. If limits are needed instead of giving an easement, the neighboring property owner should consider a different type of agreement.

How to Secure Ingress and Egress Without an Easement

Because under the law easements can both give to broad a right of access from the point of view of a neighbor and too narrow a right from the point of view of the easement holder, often other types of arrangements work better for securing the rights of ingress and egress.

Owners of landlocked parcels, or other difficult to access parcels, may wish for ingress and egress rights to be part of the deed, instead of as a separate easement. This provides several advantages to the owner of the limited-access property. It makes the process of documenting the rights easier. If the owner goes to sell the property later, having the rights explicitly in the deed will put the future buyer at ease. Having rights of ingress and egress spelled out, as part of the deed to property, is easiest to achieve when buying the access-limited parcel from the landowner who also owns the neighboring property you will have to cross to get to your property.

Sometimes a property owner will want a land use agreement. A land use agreement is a contract that spells out specific duties and responsibilities between the two sides. Land use agreements should be recorded with the county, just as an easement is recorded. A land use agreement gives the parties great flexibility in determining just how much access will be granted. A land use agreement can limit the tonnage of trucks that can cross the neighboring property, or whatever limits the two sides agree to. A land use agreement will also usually explicitly state what the limited-access property owner must pay for the upkeep of any roads.

Ingress, Egress, and Due Diligence

Verifying the ingress and egress rights is an essential part of the due diligence process when purchasing property. Even when access seems obvious, the source of the ingress and egress rights needs to be tracked down. Not only may a lender require such assurances, but it also helps avoid later legal trouble.

Part of the title search process should include documenting the ingress and egress rights. Such rights should be on the deed, in the form of a recorded easement, or land use agreement. If a title search cannot find a recorded document establishing the ingress and egress rights, the seller will need to demonstrate that he or she has those rights and then explicitly convey them to the buyer as part of the transaction.

These steps may be needed, even if the property is not landlocked. If the public access point is remote to the part of the property that is or is going to be developed, or certain weather conditions make the public access point impassable certain seasons, it is prudent to have easement or a land use agreement with a neighbor that provides more reliable and practical access to the property.


The rights of ingress and egress are essential to the full use of any property. In this article we talked about ingress, egress, and easements in depth, as well as alternatives to easements. Ensuring that you understand both what rights you have with respect to your neighbor’s property as well as what rights others have with respect to your property is a key part of the due diligence process.

How to Use The Modified Internal Rate of Return (MIRR)

The Modified Internal Rate of Return, often just called the MIRR, is a powerful and frequently used investment performance indicator. Yet, it’s commonly misunderstood by many finance and commercial real estate professionals. In this post we’ll take a deep dive into the concept of the MIRR. We’ll define the MIRR, look at the logic and intuition behind the MIRR, dispel some common mistakes and misconceptions, and finally we’ll tie it all together with a relevant example.

What is MIRR?

First of all, what is the definition of MIRR? The Modified Internal Rate of Return (MIRR) is a variation of the traditional Internal Rate of Return (IRR) calculation in that it computes IRR with explicit reinvestment rate and finance rate assumptions. The MIRR accounts for the reinvestment of any positive interim cash flows by using a reinvestment rate, and it also accounts for any negative cash flows by using a finance rate (also known as a safe rate).

The reason why these two rates are used is because it allows for any positive cash flows thrown off by an investment over the holding period to be reinvested at the “reinvestment rate”. It also allows any negative cash flows to be discounted back to the present time at the “finance rate” to determine how much needs to be set aside today in order to fund the future cash outflows.

By using this approach, the MIRR boils a set of cash flows down to just two numbers: 1) a single initial investment amount at the present time and 2) a total accumulated capital amount at the end of the holding period. Then, a single rate of return can be calculated using only these two numbers, which results in what’s known as the MIRR.

MIRR Example

Let’s take an example of the modified internal rate of return to see how this works. Suppose we have the following set of cash flows:

MIRR Example Cash Flows

We invest $100,000 today and in return we receive $18,000 per year for 5 years, plus at the end of year 5 we sell the asset and get back $100,000. If we use the traditional Internal Rate of Return (IRR) calculation, we get an IRR of 18%.

As you may recall, one of the problems with the traditional IRR calculation is that it doesn’t account for the reinvestment of interim cash flows. So, how can we use the Modified Internal Rate of Return to eliminate this problem?

First, let’s explicitly define a reinvestment rate for all of the $18,000 interim cash flows. In order to account for the yield we can earn on these interim cash flows, let’s assume we can reinvest them at a rate of 10%. Note that this rate is lower than the above calculated IRR. This could be for a variety of reasons. For example, it could be the case that we can’t find any other investments that yield higher than 10%.

MIRR Reinvestment Rate

As shown above, we simply take each of our interim cash flows of $18,000 and then compound them forward at a rate of 10% to the end of year 5. When we add up all of our cash flows at the end of year 5 we get a total of $209,892. By doing this we have transformed our initial set of cash flows into a different time value of money problem, which takes into account the yield we earn on interim cash flows that are reinvested elsewhere. Now we can simply take our new set of cash flows and solve for the IRR, which in this case is actually the MIRR since it’s based on our modified set of cash flows.


As you can see, the MIRR when using a 10% reinvestment rate is 15.98%. This is less than the 18% IRR we initially calculated above. Intuitively, it’s lower than our original IRR because we are reinvesting the interim cash flows at a rate lower than 18%. Also take note again that the MIRR calculation here is simply the IRR calculation. The only difference is that now we’ve transformed our initial set of cash flows into a new, modified, set of cash flows. That means that when we now calculate the IRR it’s a modified IRR.

MIRR Example With Negative Cash Flows

Using the reinvestment rate on positive interim cash flows like we did above is how MIRR is commonly used, but sometimes there is more than one negative cash outflow during the holding period. Consider the following set of cash flows:

modified internal rate of return cash flows

We have the same initial $100,000 upfront investment, but now we also have to come out of pocket $50,000 in year 2 for a capital expenditure. However, once this improvement is realized, our cash flows increases from $18,000 to $25,000 and now we can also sell the property at the end of year 5 for a higher price. This results in a higher IRR of 19.33%, but what does it do to our MIRR?

Let’s first tackle the positive interim cash flows by compounding them forward to the end of year 5.

Modified Internal Rate of Return Reinvestment Rate

This is the same process we followed in our first MIRR example, but now we simply ignore the negative cash outflow in year 2. This leaves us with a -$100,000 initial investment, a -$50,000 cash outflow in year 2, and a $309,104 cash inflow at the end of year 5. Next, let’s discount our -$50,000 outflow back to the present time at our finance rate or safe rate.

MIRR finance rate safe rate

This simply tells us that if we want to have $50,000 available to spend in 2 years, then we need to set aside $45,351 today in an account earning 5% annually. So, now we’ve transformed our original set of cash flows into a new modified set of cash flows that has just two figures: a $145,351 initial investment and a $309,104 accumulated capital amount at the end of the holding period.

MIRR calculation 2

Now we can simply calculate an IRR on the above modified set of cash flows to get a Modified Internal Rate of Return of 16.29%. This modified internal rate of return now accounts for the funds we need to set aside today at a safe rate in order to fund future capital outlays. It also accounts for the reinvestment of all interim cash flows at our expected reinvestment rate.

How MIRR Solves the Multiple IRR Problem

You may recall that one of the problems with the traditional IRR calculation is that there are as many solutions to IRR as there are sign changes in a set of cash flows. Let’s take a look at an example set of cash flows:

Multiple IRR Example

When you run an IRR calculation on the above set of cash flows you indeed get multiple solutions. For the above set of cash flows we get 3 different IRR solutions: 0%, 100%, and 200%. So, which one is correct? The answer is that all of them are correct! Why is this? The short answer is that the IRR formula is not a linear equation but instead it’s a polynomial which can generate multiple solutions. This is also the reason why the IRR function in Excel asks for a “guess” as an input. This is used to help Excel determine which solution is correct in case there are multiple solutions.

The good news is that the MIRR eliminates this well-known problem with IRR. To see how, let’s run the MIRR on the above set of cash flows using the same procedure we followed above. We’ll skip the interim steps of discounting negative cash flows at the safe rate and compounding interim positive cash flows at the reinvestment rate. However, this process is exactly the same as we followed above and it leaves us with the following modified set of cash flows:

multiple IRR MIRR solution

And now when we calculate an IRR on this modified set of cash flows we get 2.30%. Using the modified internal rate of return eliminates the multiple IRR problem because we are explicitly defining our safe rate and reinvestment rate. This boils the set of cash flows down to just two figures, resulting in a single MIRR figure.


In this article we discussed the logic and intuition behind the modified internal rate of return, or simply the MIRR. The MIRR is a powerful investment metric that is gaining in popularity since it eliminates the problems with the traditional IRR calculation and also provides a more realistic measure of return. In this article we broke down the MIRR calculation step by step to make understanding the mechanics of MIRR easy to understand.

The Role of Title Insurance in Commercial Real Estate Transactions

Title insurance is one of the key pieces of any commercial real estate transaction. Without it, buyers and sellers would most likely find the risks of buying and selling property to be too high. Title insurance has been around in one form or another in the United States since 1874. The stronger your understanding of what title insurance is and its role in commercial real estate transactions, the better prepared you are for negotiating great deals and protecting your assets.

What is Title Insurance?

Title insurance is insurance that protects the buyer from any problems with the chain of title to a piece of real estate. Title insurance is used in both residential and commercial real estate transactions. Because the amounts of money are bigger, financial transactions are more intricate, and title is often more complicated, title insurance plays a vital role in the buying and selling of commercial real estate.

What Title Insurance Protects Against

Title is the right to ownership of a parcel of real estate. Deeds convey title between buyers and sellers. But, not all deeds convey full ownership of the property and real estate can be subject to liens or other encumbrances that limit the rights of ownership.

A buyer in a real estate transaction is buying insurance that the title to the property they are seeking to acquire is just as the seller promised it is. If a seller claimed to convey full and clean title to a buyer, but later a third party claimed that they actually had the rights to the property and not the seller, the title insurance will protect the buyer.

Every policy is slightly different, but typically the title insurance will cover the legal fees over the title fight and in the event that the third party prevails and is awarded the property the buyer paid for, reimbursement to the buyer.

The Role of the Title Search

Before a title insurance company will issue a policy, they will conduct a title search. This involves examining all of the recorded property transfers for the property in question. This research is called a title search.

The title search does not just trace ownership, but also looks at liens and other encumbrances, such as easements, that have been made against the property. During the title search every effort is made to ensure that the results of each lien and transfer are known.

At the end of the title search a preliminary title report is issued for the buyer and seller to examine before the title insurance policy is issued.

Different Types of Policies and Endorsements

Title insurance companies typically offer two different types of policies. There are loan policies and owner’s policies. Loan title insurance policies are designed to protect the investment of the bank or other lender should any problem with the title later surface. An owner’s title insurance policy is designed to protect the buyer or owner of the property from the future discovery of problems with the title to the property.

Title companies also offer a variety of endorsements for title insurance polices that protect against more than just title issues. These endorsements may cover things such as boundary mistakes, zoning conflicts, and environmental issues. The cost of the endorsements varies considerably depending on the risk factors and the value of the property.

Getting Title Insurance

There are numerous title insurance companies all over the country. Because title insurance agents also often act as the escrow agent in commercial real estate transactions, the buyer and seller must agree on which title company to use. The title insurance company is brought into the process early on, before closing. The title insurance process begins at the end of the due diligence phase and lasts through the completion of the sale.

The American Land Title Association (ATLA) governs the industry standards for the issuance of commercial real estate title insurance.

How is Title Insurance Used in Commercial Real Estate?

While title insurance in residential real estate is often seen as a mere formality, title insurance is an integral part of both the due diligence phase and the closing process in commercial real estate deals. Because the stakes are so high in commercial real estate, all of the parties from the buyer and the seller to the lender or lenders have a vested interest in making sure the title insurance issuance goes smoothly.

Who Pays for Title Insurance and Who Owns the Policy?

If a lender is involved in the transaction, the buyer will almost always pay for the loan title insurance policy. The cost of the policy is often rolled into the cost of the loan. If there are multiple lenders, each lender will require their own policy.

The buyers will also want an owner’s title insurance policy. Sometimes the seller will pay for this policy as part of the closing costs. However, as a practical matter, the buyer is the one ultimately baring the cost of the owner’s title insurance policy, as the seller will just add the cost into the purchase price.

The party who benefits from a title insurance policy will not necessarily be the same as the party who pays for the policy. While the buyer may be paying for the loan policies, if something goes wrong with the property, it will be the lenders that benefit from the policy, not the buyer.

The issue of who benefits from the policy is why buyers should have a separate owner’s policy. Even if the seller is paying for the policy, the buyer will benefit from the policy should there be any trouble with the title at a later date.

The Title Insurance Agent

While the title insurance agent is most irrelevant in residential real estate deals, they often play an integral part in commercial real estate deals. The title insurance agent will make sure the title search is conducted in a timely manner, communicate with the buyer and seller about the status of the title search, and the issuance of the preliminary report. Most of the time the title agent will also act as an escrow agent for little or no extra charge. He or she helps keep the closing process streamlined.

What Happens When Something Goes Wrong With the Title?

While most insurance products that you buy are to protect you against some future problem, title insurance protects you against something that may have already happened, but that you aren’t aware of yet.

If someone later comes forward to challenge your property rights or title to the property you will have to make a claim with the title insurance company. Depending on what your policy covers and what endorsements you purchased, the title insurance company will usually investigate the challenge and defend you against it.

Very early in the process a commercial real estate lawyer will be brought into help evaluate the claim and try bringing a swift end to any challenges. However, like all legal matters, disputes over title to a property can drag on for several years.

The Preliminary Title Report

One of the most important documents in the entire commercial real estate transaction is the preliminary title report. After the title search is completed, the title insurance company will issue a preliminary title report that explains its findings. This report will show any liens or other encumbrances currently made against the title to the property. It will also make a statement as to the title the seller has to the property. If any property rights have been previously sold, such as water or mineral rights, the title report will indicate when the transfers were made and to whom.

What Does the Report Mean to the Seller?

Once the preliminary report is issued the seller has a chance to review the report and challenge any of the findings. If there are any errors, the seller can demand that the errors be corrected and a new preliminary report issued.

If the report finds that the seller does not have the clear title that they thought they had, the seller can do their own investigation or go back to the title insurance policy they were issued when they purchased the property.

There is a small window of time for the seller to make any objections to the preliminary title report before it is made final.

What Does the Report Mean to the Buyer

The buyer needs to carefully review the report to ensure it substantiates the seller’s claims as to title and property rights. The policy will be based on the preliminary report. If there is anything the buyer is uncomfortable with, the preliminary report represents their last chance to pull out of the deal without severe financial consequences.

The buyer can also make objections to the report if there are inaccuracies.

Accepting the Preliminary Report

Once the objections of both sides have been dealt with, the parties will accept the report and it will be made final. The final report will become part of the title insurance policy that is issued to the lenders and the buyer.

After the report is accepted and the insurance issued, the rest of the transaction will quickly close. The title insurance agent, acting as escrow agent, will transfer the funds to the seller and the executed title documents to the buyer.


Title insurance makes commercial real estate transactions possible and keeps the closing process running smoothly. Without title insurance it would be impossible to get lenders to risk large amounts of capital on complicated transactions and buyers would be much more reluctant to buy from strangers. In this article we covered the role of title insurance in commercial real estate transactions, and along the way we outlined how it works, why it’s important, and what could go wrong.

Definitive Guide to the Commercial Real Estate Closing Process

When it’s time to on a commercial real estate transaction the process can seem overwhelming. This definitive guide will walk you through every step in the commercial real estate closing process. You will see where the commercial process is similar to the residential process, and where things are different. You will also discover the places you need to be cautious and where your due diligence efforts are most important. Commercial real estate has fewer protections for buyers, but also gives parties more room to be creative with deal making.

There are four major steps to closing a commercial real estate deal. Some of these steps are ongoing and others overlap. Every transaction will go through escrow, signing authority verification, due diligence, and signing and processing title and closing documents.


Just like when you purchase a home, escrow is an important part of the commercial real estate closing process. In escrow a neutral third party will hold funds in an account until either all of the requirements of the escrow agreement have been met, or until one party pulls out of the deal in accordance with the terms of the escrow agreement. Escrow is designed to solve the problem of trust between two parties. Nobody gets paid or receives title to the property until both parties have had their agreed upon conditions met.

Escrow in a Commercial Real Estate Transaction

Most private home sales have an informal escrow process. Because commercial sales often involve larger sums of money and are more complex, escrow in this setting is formal and tightly controlled. Capital for a commercial transaction will often come from many different sources. Additionally, because there is less regulation of commercial real estate deals the parties must do more due diligence to protect their investments. The paperwork involved is highly customized and more extensive than the form documents used when buying a home.

The parties will often have negotiated an escrow agreement that the escrow agent must verify has been satisfied before releasing any funds.

Title Agents as Escrow Agents

While there is no legal requirement for who the buyer and seller must chose to serve as the escrow agent, most of the time the title agent will act as escrow agent. Title agents are usually already familiar with the details of the transaction and have no financial interest in the success or failure of the deal as their fee is for services rendered regardless of the outcome of the deal. Title agents also have the expertise to create the customized closing documents vital to most commercial real estate transactions.

Escrow Agreement

Before money can be transferred to the escrow agent, the parties have to come to some agreement as to what the escrow agent’s duties are and what will satisfy escrow and allow the funds to be released to the seller of the property.

Unlike residential sales, the escrow agreement in commercial real estate closings is unique for each deal. However, there are several common escrow agreement provisions such as:

  • Clause appointing the title agent to act as escrow agent and to waive any fee acting as an escrow agent
  • Clause ordering escrow agent not to commingle funds sent by the buyer with any other monies.
  • Statement of when written instructions from buyer and seller need to be received before funds can be released.

Typically escrow agents won’t have any responsibility for verification of any part of the deal other than only releasing funds when instructed from both the buyer and the seller. Instructions to release the funds are almost always required to be in writing.

Dealing With Legal Entities and Authority

Instead of a contract between two people, a commercial real estate deal involves one or more contracts between two or more legal entities. Because these deals are expensive all parties want to limit their liability and often create legal entities for the sole purpose of owning a piece of commercial real estate. For every entity such as a corporation, LLC, or LLP involved, additional steps must be taken to verify their fitness and ability to conduct the transaction.

Why Legal Entities Are Used

One feature of American law is that investors in a corporation are shielded from loss or liability for the actions of the corporation up the amount of their investment. In other words, if a corporation gets sued the investors may lose their investment in the corporation, but their personal assets will not on the line. This same protection also extends to LLC’s and LLP’s in most states.

Investors know that commercial real estate can come with large risks. Legal entities are used to protect individual investors from liability both as sellers and buyers.

Even existing legal entities buying additional property will sometimes create a new legal entity or subsidiary, to isolate the risk of acquiring or selling a piece of property.

In many states there are tax advantages to owning commercial real estate in a legal entity.

Signing Authority Verification

A corporation or other legal entity may be the actual party to a transaction, but a human being will still need to sign and execute documents of the behalf of the entity. This creates an extra layer of paperwork in the commercial real estate closing process.

Both sides will want proof that the person signing on the dotted line has the authority to do so. This is called signing authority. Proof of signing authority can be in the form of a corporate charter that expressly gives the individual such authority, letters of authorization from the president, CEO, or board of directors of the entity, or a resolution from the board of directors or equity partners.

Until documents demonstrating signing authority have been received, a party will not allow the money in escrow to be disbursed. The seller wants to make sure the buyer has the legal authority to commit to the transaction and the buyer wants to make sure the seller is legally authorized to dispose of the asset.

Making Signing Authority Easy

Before proceeding too deeply into a commercial real estate deal, you should make sure the proof of signing authority will not be an issue for your legal entity. Here are a few ways to setup authority before entering into a transaction:

  • Designate someone by name or title in the corporate charter to have the authority to enter commercial real estate transactions.
  • Get authorization from the board of directors to execute the purchase or sale of a specific piece of property
  • Have a signed and notarized letter from the other partners authorizing the transaction and designating someone to have signing authority on behalf of the entity.

By making sure the authority issue is resolved before the closing process you will save valuable time.

Lack of RESPA and Due Diligence

The Real Estate Settlement Procedures Act (RESPA) is the main federal law that governs residential home sales. This law requires sellers to make several guarantees and warranties to buyers about the condition of the property and the absence of a variety of environmental defects. RESPA also governs the form of closing documents that can be used. The purpose of the law is to protect homebuyers from being deceived and buying a house that is dangerous or uninhabitable. RESPA does not apply to commercial real estate transactions.

What the Lack of RESPA Means to Commercial Real Estate Closings

The lack of RESPA affects commercial real estate closings in two major ways. One, it means that buyers and sellers must perform detailed due diligence on the property and the other parties to the transaction, which can delay the closing of the deal. Two, the lack of RESPA frees the parties to be more creative in structuring the deal and in they types of closing documents they choose to use.

During a commercial transaction the buyer is constantly trying to preserve the right to withdraw from the deal as long as possible and the seller is trying to limit the right of the buyer to withdraw. Buyers are looking to add contingencies and sellers are looking to close all contingencies long before escrow and the closing process. The buyer is also trying to keep the seller on the hook for any problems that become apparent after the sale for as long as possible while the buyer wants to terminate its liability as close to the closing date as possible. These tensions are reflected in the due diligence process and the form of the closing documents.

Due Diligence

Because there are fewer state and federal protections for buyers and sellers in a commercial real estate transaction, the due diligence process is much more extensive.

Buyers will want to make sure the following areas are in order:

  • The contract of sale has been properly executed
  • Receipt of most recent title insurance policy
  • Updated survey report
  • Receipt of true copies of all leases
  • Review of new environmental report
  • Termination notice conditions and due diligence deadline
  • Delivery of all tenant estoppels
  • Review of the seller’s books and records
  • Confirmation of zoning compliance
  • Search for any outstanding tax cases or liens

Sellers will want to make sure the following are in order:

  • The contract for sale has been properly executed
  • Buyer has delivered down payment to escrow agent
  • The escrow agent has deposited the money in a segregated interest bearing account
  • Filed a response to any objections to the title and survey report
  • Execution of assignment and assumption of leases by buyer

Every transaction is different and certain deals may require even more steps in the due diligence process than those discussed above.

No RESPA and Commercial Real Estate Closing Documents

In addition to the due diligence procedures discussed above, both parties will want to make sure all of the closing documents are reviewed for accuracy and properly executed on time.

In residential real estate transactions RESPA requires use of a specific form for all closing documents. In the commercial real estate closing process the parties are free from the RESPA requirements and can draft the closing documents as they see fit. This will often cause some back and forth as the parties negotiate over the exact form the documents will take, but it also gives the parties more flexibility to get a deal done that both sides can live with.

Title and Closing Documents

Before a deal can be completed the buyer and seller must both agree to accept a title report and execute a series of closing documents. The closing documents may include assignments and assumption of leases, deeds, environmental reports and assignments of liability, zoning disclosures and warranties, and anything else the parties decide is necessary to close the deal.

Commercial Title Issues

Earlier in the process of negotiating the transaction a title company will be hired to issue a preliminary report of the state of the title to the property. Commercial real estate titles are often much more complicated than residential titles. There are any number of liens and encumbrances such as easements that have to be accounted for. Often the seller may no longer hold some of the below ground rights such as mineral or water rights.

Once the preliminary report has been issued the buyer must carefully review it and file any objections or concerns to the report under a deadline. If the buyer has any objections the seller often has a limited period of time to respond to the objections of the buyer can walk away from the transaction.

Once all of the issues with the title have been settled the title company will issue the final report. Both the buyer and the seller will then review this report for errors or concerns and any issues will have to be resolved before the transaction can move forward.

Zoning/Building Jackets

Buyers will want reassurances that the property is correctly zoned for its current use and for the buyer’s intended use. As part of the closing documents the parties will want a report that proves a zoning and building jacket search have been conducted and that there are no known zoning issues. Depending on the jurisdiction, this report may include letters from the local municipalities, endorsements to the title of the property, or a detailed report from the title company.

Environmental Reports

Because liability for environmental problems can be so severe, the parties will usually require a separate report and document to deal with the current understanding of environmental issues such as a known wetland or known ground or water pollution. The buyer will want some statement from the seller stating the property is otherwise free from issues and the seller will want to try and avoid making such a statement. A document detailing the final agreement of the parties as to both the nature of any environmental issues and future liability for later discovered issues will be part of most commercial real estate closings.


Like in residential transactions, part of the closing documents will be some form of deed, typically a quitclaim deed, but sometimes a special warranty deed is used. This document once recorded officially transfers ownership of the property from buyer to seller. A title affidavit will also accompany the executed deed.

Federal laws such as the Patriot Act, also require that a non-foreign entity affidavit be executed with the deed.

The title and the terms of the deed will have been reviewed and discussed long before the formal closing documents are executed.

Assignment and Assumption of Leases

Unlike in a residential transaction, a commercial real estate closing will include an assignment and assumption of leases. This document explains that the benefits of any lease transfers from the seller to the buyer. It also transfers future liability for breaches of the lease from seller to buyer and details responsibility for lease breaches prior to the sale. This document also notifies tenants of the change in ownership.


The commercial real estate closing process is more involved and complicated than the residential real estate closing process. Because there is less federal regulation of the process, the parties have greater freedom to structure the deal and the closing documents, but both sides also must exert greater due diligence. Because of the large amounts of money involved and a variety of sources of capital escrow is more formal and both sides of the transaction are usually legal entities. The closing process takes longer in commercial real estate deals, but there are more tools to resolve issues than in residential purchases. This article gave a broad overview of the commercial real estate closing process, but as always, it’s best to consult a competent real estate attorney to discuss your particular situation.

How Green Bonds Work in Real Estate

While the movement to make commercial real estate more sustainable is already several decades old, a new tool has been steadily taking hold in the marketplace that makes financing costly environmental upgrades attractive to investors and issuers. Green bonds have grown from just $12 billion in 2013 to over $36 billion in 2014. This year looks to see green bonds continue to sell at the 2014 level. Investors and issuers have both found a lot to love in green bonds.

What Makes a Bond “Green”?

Green bonds refer to debt financing instruments that are issued for the purpose of creating new developments or upgrading existing infrastructure in a way that is environmentally sustainable. Traditionally the biggest issuers of green bonds have been the World Bank and various national governments and municipalities. However, increasing private corporations are issuing green bonds to fund the renovation of buildings to make them more energy efficient and other environmental upgrades.

There are not any internationally accepted standards for what makes a bond “green”, but lenders often tie the issuance to specific and verifiable conditions that the borrowers must follow to qualify. With the rapid growth of this sector further regulation and an international consensus about green bond standards seem likely in the near future.

How Are Green Bonds Being Used?

In the United States one type of green bond that has been especially attractive are tax free bonds issued by federally qualified organizations or municipalities to clean up brownfield sites. Brownfield sites are specific areas that are underdeveloped or are in a state of urban decay. Often these areas have low levels of industrial pollutions as well.

Under the federal Qualified Green Building and Sustainable Design Project Bonds program, developments can qualify for tax free bond status if it meets three conditions:

  • The development project will receive at least $5 million dollars from a municipality or state
  • 75% of the development buildings register to receive LEED Certification
  • The building or buildings are at least 2 acres in size

Beyond this federal program, cities, counties, and private lenders are creating more green bond programs. Investors seem eager to invest in these instruments because of their relatively good yields and the social dividends they produce.

Many organizations are also looking at securing green bonds as a way to finance much needed energy efficiency upgrades to HVAC systems and to lower occupancy costs by improving the overall energy footprint of their buildings.

The powerful GRESB recently released a set of comprehensive guidelines for green bonds for the real estate industry. Among the recommendations is that lenders tie the bonds to the borrowers securing energy efficiency certification from a third party such as Green Star, LEED, or BREEAM.

Currently most real estate green bonds are used for projects that fund construction of green buildings, energy efficiency upgrades, on site renewable energy generation such as solar panels, sustainable waste management upgrades, and sustainable water management.

Tax and Interest Rate Advantages of Green Bonds

Green bonds may be aimed at a social good, but unlike many attempts at using market mechanics to make social gains, green bonds do not require any type of good conscience premium. The returns on green bonds are in line with other conventional bonds. This is goods news for supporters who see green bonds as a chance to reward private investment in environmentally friendly development.

Because many green bonds are issued by government entities many are tax free bonds. Investors looking for safe investments with reliable cash flow and tax savings are drawn to green bonds.

Some private borrowers are drawn to green bonds because they give companies a certain “green” cache and allow them to get dedicated funding for projects that make sense to the bottom line like installing solar panels or upgrading the energy efficiency of a building by improving ventilation or electricity conservation.

Downsides of Green Bonds

But, not everyone sees green bonds as a great social win. Instead of growing in the first half of 2015, demand for green bonds remained steady. This disappointing trend is particularly stark after the huge spike in the sector the previous year. One of the main drags on the industry is a lack of standards.

Any project could be labeled “green” and marketed to potential buyers under that premise. The lack of standards has some investors who should be excited about investing in green bonds worried.

The lack of clear standards has also affected borrowers. Many lenders want to make sure a project is objectively “green” and require many levels of verification as a requirement to issue a green bond. Borrowers are wary of the extra time and costs required. Some worry that the savings they hope to gain will be postponed a year or two further down the road because of the costs of getting certifications and meeting the lender’s verification requirements.

Critics question whether green bonds are more than a public relations move for companies that could get the same types of projects funded under more conventional terms. They note that unless a code of green bond standards emerges, the industry really is dependent upon the good feelings investors get for putting their money into green projects. The worry is that the good feeling of investors is not a sustainable trend.

The Future of Green Bonds

Green bonds have rocketed out of obscurity just a few years ago to become a major force in the bond market. While there is currently a surplus of solid debt options for investors, green bonds seem unlikely to recede back into obscurity.

The public relations benefits of green bonds look to continue to be significant, and many aging buildings continue to need major environmental upgrades to remain profitable and attractive to future tenants and buyers. The single biggest obstacle for the wider acceptance of green bonds is the lack of standards.

However, with groups like the GRESB becoming more involved in pushing common standards, an industry standard for green bonds seems likely to evolve in the coming years. It also seems highly unlikely that the SEC will let a segment as large as green bonds continue to exist without tighter standards to protect investors from the unscrupulous issuers of standard bonds in green bonds clothing.

For now, whether you are an investor, an issuer, or a borrower, there is a lot of money at stake in green bonds, and the sector isn’t going away. Through solid due diligence all sides of a green bond transaction can still get a great deal and profit handsomely, while also making the planet a cleaner place to be.