Stack it Up: Considerations for Navigating the ‘Buyer’s Market’ for Real Estate Financing (article)
The current environment for real estate financing continues to be favorable for the right types of projects. Interest rates remain at relatively low levels, which is good for developers and owners. Private real estate investment capital is also increasing; U.S. levels are around $147 billion according to Preqin. At the same time, Preqin finds that deal volume has been lower than in 2016. Lower interest rates and high interest in real estate investments make for a perfect storm for real estate owners.
With so many options, it will be critical for real estate owners to find the right capital stack for their projects. The key will be understanding the advantages and opportunities of each level of the capital stack and evaluating how they match up to your overall strategy.
Senior Debt – Low Cost of Funds
If you have a long-term project, you may want to consider a capital stack that is significantly financed by senior debt. Costs of funds are at historical lows, and the banks are still hungry for deals. Now is the time to lock in interest rates for the long-term on senior debt for real estate before the interest rate environment changes.
The actual price differentials may be minimal between the term sheets offered by banks, so look at other things that matter, such as the terms and conditions and the length of time until maturity. While you may get longer amortization periods, the term to maturity for commercial real estate is generally five to 10 years. Try to get the longest maturity possible. Also, most banks will only offer a floating rate, and they may also offer an interest rate hedge through an interest rate swap derivative. Real estate owners who hedged floating rate debt over the past decade paid for something they didn’t need as rates stayed extremely low, but you never know what the future holds. An interest rate increase is expected in December, and a new chair of the Federal Reserve will be taking over in early 2018. If economic activity begins to pick up and with the proposed changes to the tax code and other initiatives coming out of Washington D.C., interest rates might increase. The extra cost of an interest rate swap would be worth your while if the base interest rates start to move up into the traditional range of 4 percent or more.
Mezzanine/Subordinated Debt – Filling the Gap
If there is a gap between the senior debt amount and the equity portion, then the developers/owners might want to consider mezzanine or subordinated debt. While this type of financing is more expensive than senior debt, it is less expensive than equity. The rates are in the low- to mid-teens, depending on the property, project and cash flows. The devil is in the details.
Equity – Are You a One-Off Deal or a Program?
Probably the most important thing when finding equity for real estate is, are you looking for a single transaction or are you looking for a partner and building a program of multiple transactions? That one question will separate potential investors into different categories. For one-offs, it is all about that particular property. For a program, it is more about the management team and their strategy. Certain investors want specific types of real estate or projects while some want certain geographies and others are looking more to the numbers and the cash flows. All of them will want to know details about the exit strategy and what their options are if the program or one-off goes sideways. Most of the equity investors need to see the developers/owners have skin in the game of 5 to 10 percent. There is no such thing as sweat equity, and the raw land alone doesn’t count for what it used to.
If you have the details sorted out for your CRE project, the next step will be identifying interested investors. Once again, it’s the owner/developer’s market. Institutional investors have shown interest in the CRE market as projects tend to produce stable income and low risk.
Find the Fit for You
At the end of the day, your capital stack for a CRE project is unique to your circumstances, including the project and the level of risk you’re looking to take on. With the uncertainty over tax reform and expected interest rate hikes, now may be the perfect time for owners and developers to secure their financing for their next project.
An experienced advisor may also be able to help with navigating the capital stack process. For comments or questions about capital stack financing, contact Jake McDonald (firstname.lastname@example.org, 610.862.2202) or your local CBIZ advisor.