Residual Value Insurance

This coverage is relatively new for commercial real estate investors, though the concept is not new and is common in equipment and vehicle leasing.

In an auto lease, for example, the Lessor’s return is dependent upon the value of the auto at the end of the lease. When the vehicle is leased, residual value insurance is written protecting the Lessor from a drop in the value of the auto at the end of the lease term.

Same concept, different market: If a triple net lease that includes a balloon payment is used, an element of real estate risk is introduced into a credit-based transaction.

While this doesn’t sound beneficial, a mortgage with a balloon payment is often preferred in a credit tenant lease because it benefits cash flow for the borrower that can then be used to further invest in the business or to service other debt. The risk is that, because all the rents have been used for debt service on the loan, if the value of the real estate is insufficient to cover the balloon, the loan is at risk of not being fully repaid.

Residual Value Insurance guarantees to the lender that if the asset is not of sufficient value to ensure the payment of the balloon, the final payment will be made by the insurer.

Highlights of the policy:

The policy is written at the time of loan origination
Premium is paid up-front
Policy is non-cancelable once premium is paid
The insurer is written into the mortgage documents as a successor and assign in the event of default, takes the lender’s position as first mortgagee and all rights of recovery associated with that position