FEATURE ARTICLE, FEBRUARY 2007

THE LOWDOWN ON ALTERNATIVE LENDING OPTIONS
Widely available capital and increased competition has led to a surge in alternative financing options.
Mitchell Mondry

Awash in money with countless choices — that is the environment in which real estate principals seeking capital find themselves immersed these days. Seemingly endless sources and types of capital are available to prospective borrowers.

Mezzanine debt has become extremely flexible, cost competitive and popular. Once found primarily in the private equity arena, in just the past few years, mezzanine debt has become a mainstay of real estate capital structures. Where traditional senior loans’ loan-to-value ratios historically maxed out between 65 and 75 percent, depending on the type of property, mezzanine loans are now widely available to increase debt funding into the 80th percentile, and in some cases into the high 90s. With the proliferation of mezzanine lenders and products, developers are able to leverage properties to levels not seen since the mid-1980s.

Many senior lenders now offer one-stop shopping for borrowers by providing both the senior and subordinated tranches of debt. An ever-growing number of banks are offering mezzanine debt as a way to capture a larger proportion of the capital structure and increase their yields. As margins have been compressed by the abundance of senior debt, lenders can increase their yields by providing the higher-risk layer of subordinated debt as well. While often documented as two separate debt instruments, the process is seamless to the developer and moves more quickly than negotiating with two lenders.

A development related to this new trend, which is also leading to the increased availability of capital, is that some lenders are now providing equity in various forms. Equity is the ownership stake invested in the property, usually invested by the property owner or developer. Typically, it is the highest risk money in the deal, as it is paid back after repayment of debt and other costs. In some cases, a lender will take a back-end participation in the developer’s profits in exchange for providing more capital. This mechanism can improve the yield on the debt and permit the lender to be cost competitive on the front-end to win the deal. For example, assume a lender provides $10 million of debt, with a 7 percent interest rate and a participation of 400 basis points. Upon sale of the property, the lender receives return of principal, all unpaid interest, plus 4 percent of the owner’s profit. If the profit on sale is $2 million, the lender earns an additional $80,000 yield.

A similar trend finds lenders providing earnouts and future funding on non-stabilized properties. The initial loan may be at a 65 percent loan-to-value ratio, with the opportunity to increase to 75 or 80 percent as the property income stabilizes. In this way, the borrower is able to secure a commitment for additional debt funding before closing on the purchase, thereby reducing the amount of equity required to be invested. The lender benefits by offering a higher loan-to-value ratio to the borrower, without bearing the risk of the time period before the property reaches income stabilization.

Another emerging development finds some lenders providing preferred equity to borrowers, often supplying up to 90 percent of the capital required to fund an acquisition or development. The preferred equity falls behind the senior debt, and is typically pari passu with the developer’s existing equity. The preferred equity typically receives a preferred return of 8 to 9 percent and the lender receives a share of the developer’s profit. Often the split has a “waterfall” provision that pays a higher percentage of distributable cashflow to the lender until the lender reaches a certain threshold return. For example, first available cash may be split 70 percent to the lender and 30 percent to the developer until the lender has achieved a 12 percent return. Thereafter, any additional cash may be split 50/50 between the two parties.

One reason for the increased availability of capital is the explosion of collateralized debt obligations, commonly known as CDOs. Because they are securitized instruments, CDOs offer liquidity for loans that heretofore provided limited liquidity to the lender. CDOs are not only becoming more common, but also substantially more creative. For example, construction loans are now being packaged as CDOs and sold to the public market. In some cases, loans are securitized by the issuer and sold on Wall Street; in others, entities such as hedge funds are buying slices of loan securitizations, repackaging them as CDOs and selling them off in tranches.

Recently, CDOs have been created on the basis of land loans. Traditionally the riskiest sector of real estate financing, loans for vacant land are issued at lower loan-to-value ratios, and often require personal guarantees or other security measures. With the advent of land-based CDOs, lenders are now able to originate and sell loans on non-income producing property, basing the yields on projected cash flow. This development provides a new liquidity exit for land lenders.

In today’s market of capital products, senior and mezzanine debt are just the beginning. There are countless other sources of capital for real estate, some public, some private. By utilizing layered capital offerings, borrowers can get the most out of the financing industry for their project. Often the only limitation on available capital is the borrower’s creativity and determination. There are many forms of credits, which can be specific to the location of the property or the type of asset. Examples of available credits include Tax Increment Financing (TIF), Brownfield Tax Credits, Historic Tax Credits, and Conservation or Preservation Easements. Each of these can provide millions of dollars of capital if a prospective property qualifies and if the owner is willing to wind its way through the approval process. Other options include certified development company loans through the Small Business Administration, and loans or grants from special purpose entities that are often created to spur economic development in a designated area.

In one recent example of the diverse lending landscape, a building in downtown Detroit was purchased utilizing financing totaling $146 million in 13 funding packages from ten different sources. The structure included a traditional senior mortgage from a commercial bank; historic Michigan Small Business Tax credits; an interest-free loan from the Detroit Development Authority; a mezzanine loan from the Detroit Investment Fund; Michigan Brownfield credits; a HUD section 108 loan; Empowerment Zone bonds; a federal tax credit; and a bit of equity to support it all. With a little ingenuity, and a lot of patience, borrowers can identify and obtain financing from a vast array of diverse sources.

As is often the case with an abundance of supply, the wealth of choices has lead to cheaper capital. Margins are thin, yields are low and the capital market is highly competitive. For real estate professionals seeking funding for a project, now is the best of times.

Mitchell Mondry is founder and president of M Group Inc., a Birmingham, Michigan-based real estate investment and development company.



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