Only a few years ago, mezzanine loans, bridge loans or preferred equity were hard to come by. Today, capital providers are chasing the higher relative yields afforded by commercial real estate debt.
As a result, these types of structured financing appear to have returned to the market in full force.
“The terms for bridge financing have radically improved in the past 12 months,” says developer Albert Berriz, president and CEO of McKinley. McKinley recently obtained a $14,160,000 bridge loan with Bank of America for RIVA Apartments, a 278-unit community located in Southwest Orlando. McKinley has fully stabilized the property, which was originally acquired as a fractured condominium, and it now expects to close long-term HUD financing on the asset through Berkadia Commercial Mortgage later in the year. McKinley is processing about half a dozen other bridge loans that it would be closing in the early part of 2013, according to Berriz.
Bridge and other types of structured and/or high-yield financing enable borrowers to achieve certain goals. Bridge financing provides short-term loans for transitional properties, whose occupancy levels at the time of loan application may still be too low to qualify them for permanent mortgages. The loans give borrowers time to improve the property’s performance before obtaining a permanent mortgage at far more favorable terms, and perhaps even cash-out based on the higher asset value. Another type of structured financing, mezzanine loans allow borrowers to increase their leverage by obtaining a second loan in addition to their permanent loan. Another major category of high-yield financing, preferred equity allows for even higher leverage than mezz debt in exchange for profit participation.
These forms of alternative financing do not come cheap, but they are becoming less expensive. Berriz says bridge financing terms have rapidly become much more favorable since the end of last year. For the leading sponsors, in the past 18 months, pricing for bridge financing for acquisitions/rehabs provided by commercial banks has fallen to 2.25 to 2.75 percent over LIBOR, while LTV has increased from a maximum of 65 percent LTV to as high as 75 to 80 percent LTV, Berriz says.
McKinley obtains bridge financings with banks including Wells Fargo, Bank of America, CoAmerica and Bank of Chicago. Recourse is generally required by the banks, unless the deals are low leverage. Berriz says he does not obtain bridge financing from private sources, as they tend to be more pricey than banks.
Nevertheless, terms for bridge financing from non-bank players have also become more favorable. Brian Good, president of Eagle Group Finance, agrees that banks have now returned to the bridge financing marketplace to compete with the private capital sources. Bridge financing rates in the private capital market have compressed from 10 to 12 percent to 8 to 10 percent, says Good. The company allows maximum leverage of only 50 to 60 percent LTV on its bridge loans, but Eagle Group Finance competes with other bridge lenders by providing non-recourse, and flexible terms of six months to as long as 10 years, and by not imposing prepayment penalties. “We are a softer hard money lender,” says Good.
While multifamily bridge loans supply short-term first mortgages for pre-stabilized properties, mezzanine loans and preferred equity furnish additional loan dollars for higher leverage financing. The pricing of both mezzanine and preferred equity lending today “is as affordable as I have seen them in decades,” says Jeff Hudson, principal at George Elkins Mortgage Banking Co., a 92-year-old mortgage banking firm that arranges the full range of capital.
Mezzanine loans today are priced from 7.5 to 11 percent, with maximum LTVs and LTCs of 80 to 85 percent, says Hudson. As regards preferred equity, “straight yield” preferred equity is today commanding interest rates of 7 to 10 percent, and imposing maximum LTVs and LTCs of 80 to 85 percent. In cases where it is not possible to pay for the higher interest rate out of cash flow, part of the interest may be accrued.
To secure preferred equity that provides more than 80 percent financing—up to 90 percent or higher—the borrower may be able to procure preferred equity with profit participation. The financing will include a preferred payment (or interest rate) as well as provider participation in the profits, and residual value upon sale of the property. The anticipated IRR on this type of structure is in the 12 to 20 percent. Depending on the leverage and anticipated value of the property, the lender’s profit participation can be 25 to 75 percent.
Whichever type of preferred equity, part of the interest payment tends to be accrued. “Even if the preferred equity wants a return of 12 to 15 percent, the pay rate in many cases is only half of that, with the difference being accrued,” explains Sue Blumberg, senior vice president-managing director at NorthMarq Capital. The borrower is often required to refinance or sell the property at the end of the loan term. “That is when [the preferred equity provider] obtains its required return,” she says.
Hudson says that investors are increasingly interested in advancing mezzanine and preferred equity today because the yields on these types of loans are high compared to alternative investments. Mezzanine and preferred equity represent investment diversifications for many investors, he says. “They are getting higher returns to match the lower returns on the bond side of their portfolios.”
Equity investments of under $3 million and over $20 million, which are funded by private and institutional capital respectively, lies in the “middle market,” which is occupied by a mix of private and hedge funds, says Hudson. “We see more and more players in this market segment. Generally these are the same players who were there 10 years ago who have reinvented themselves or dusted off their strategies and are coming back to the market.”
What’s also helping structured financing work in today’s market are lower interest rates, which render the financing more affordable. Yes, structured financing comes at a higher cost, and the upside on the property needs to be large enough to pay for that more expensive capital. Nevertheless, “because interest rates are so low, even combined with the required returns that need to be paid out, the borrower can get into more deals,” observes Blumberg.
The availability of high leverage and transitional financing—at least for the strongest sponsors—is allowing developers to spread their dollars among more developments, and thus engage in more projects than they may otherwise. Continental Realty Advisors (CRA) acquired the 629-unit The Canyons apartment community in Phoenix by paying down $44 million in equity. It subsequently took out a two-year bridge loan of about $28 million arranged by NorthMarq Capital to lessen its equity position, says David Snyder, CRA president and chairman. CRA refinanced out of the property with a Freddie Mac permanent mortgage within 18 months. The bridge loan interest was fixed and Treasury-based. In addition to allowing sponsors to spread their equity among more properties, bridge financing is also put to use when obtaining FHA-insured financing: developers put a bridge loan in place while waiting for, and working on, the FHA financing.
As for developers who may be having difficulty obtaining the loan dollars they need, mezzanine financing may be the answer as it allows them to increase their leverage. However, one caveat is that Freddie Mac has recently disallowed mezzanine financing on properties encumbered by its mortgages, though it still allows preferred equity, says NorthMarq’s Blumberg. Fannie Mae permits mezzanine financing from five pre-approved lenders, as well as preferred equity, on properties it finances. However, the additional financing is subject to approval. The maximum LTV required by the agency on the combined financing is 85 percent, and DSCR has to be at least 1.1.
As a broker, Hudson is seeing more capital sources that are seeking to provide mezz debt, bridge financing or preferred equity come to him today. “Yes, there is now more money than good product,” he says. And that is driving the rapidly improved terms for developers.