Check out this great article, chosen by Special Assets Advisor Zachary Tuckman, about Structured Debt vs. JV Equity
LOS ANGELES-It’s no secret that real estate developers had the most to lose when the Great Recession hit in late 2007 and the commercial real estate market was hammered. From 2007 to 2010, a tightening of the credit markets resulted in stalled, half-completed or unleased developments, pushing properties into default, workouts and foreclosures. Developers took heavy hits as carried interest on land and half developed projects rapidly depleted liquidity. So what was the takeaway? How has the mindset of a developer changed and how has capital adjusted to meet the demands of the post-recession marketplace?
As an intermediary between the capital markets and commercial real estate developers, one of the most common questions that we at George Smith Partners are currently asked by developers is “How do I hold onto my developments for long term asset appreciation and cash flow?”. Cleary, one of the largest takeaways for developers, post downturn, is the value of passive income.
How Do I Hold onto my Projects?: Joint Venture Partners vs. High Octane Debt
Middle market real estate developers focusing on projects in the $20-million to $100-million range are looking for alternatives to the typical institutional joint venture. The largest drawback of the JV is that the majority of institutional equity investors target a three- to five-year hold period, forcing the developer to build and sell rather than hold for long term gain, and passive income.
Typical buy/sell arrangements require that the sponsor has to buy the property from the venture at the market value, not at cost. Traditional JV structure follows a 90/10 co-invest formula where the developer contributes 10 percent equity and the investor contributes the remaining 90 percent of the equity. Cash flows are distributed pari-passu to a preferred return whereby the developer begins to earn a promoted interest on their sweat equity after the investor hits certain IRR thresholds. A promoted interest means that the developer earns a larger ratio of net cash flow than the ratio of equity they put into the project (promotes in the 30% to 40% range are typical). Because the advance rate on non-recourse construction debt is typically 50% to 55%, developers who want non-recourse construction financing require more equity and will earn a smaller distribution of net cash flow as they struggle to pay a preferred return on a much larger tranche of equity before hitting their promote.
The alternative to joint venture equity is a combination of construction financing and mezzanine or preferred equity, commonly referred to as “structured debt,” which could include tranches of subordinate mezzanine debt or preferred equity. Mezzanine debt is collateralized by interest in the ownership entity, is non-recourse, and bridges the gap between the senior construction lenders threshold and 85% to 90% loan-to-cost. In a preferred equity scenario, the investor becomes a member of the LLC from the outset but the sponsor has specific buyout rights once target yields are achieved.
Subordinate debt lenders do command a premium for these higher risk dollars, with pricing in the 12% to 20% range. Utilizing this type of structure requires the developer to fund the remainder of the project (i.e. 10% to 15% of cost) with their own capital. The goal being that the project can support a large enough permanent loan at stabilization to take out the senior and subordinate lenders and allow the developer to hold onto their project into perpetuity. In addition, this structure can allow the developer to realize a lift in the land (post-entitlements) as the land can be contributed by the developer at its appraised entitled value as equity, which can at times be a friction point in JV negotiations.
Traditionally, when seeking structured debt, one would have to go to two separate capital providers to source debt up to 85% to 90% LTC with the senior debt coming from a traditional money center or local community bank; and the subordinate debt or preferred equity coming from debt funds, private equity funds or investment banks. This takes time to arrange and negotiations can be complex.
To meet the demands of the market, over the past six months, several investment banks, debt funds and private equity firms have introduced financing programs which make them a “one stop shop” for developers looking for high octane construction financing. These construction loans are written as a first mortgage, can get up to 85% LTC, are typically non-recourse (i.e. no repayment guaranty), and pricing ranges from 8% to 9.5%. This structure allows for certainty and ease of execution as it eliminates the need for two different capital providers to work in parallel, and obviates the need for a protracted and expensive negotiation of an intercreditor agreement.
In all, the high-octane debt structure remains as a great non-recourse option that allows developers an opportunity to hold onto their projects, provided they have the equity. Of course, there are downsides to this structure; since the project is more highly leveraged than a typical JV structure; the breakeven point is higher, putting pressure on cash flow.
As a takeaway, the demand for institutional JV equity will remain extremely prevalent and continue to serve as a great source for developers looking to bolster their balance sheets coming out of the downturn, with little of their own equity at risk. However, as balance sheets become more liquid and developers rebuild their capital, we will be seeing a continuing trend towards structures that enable developers to retain their assets.