Structured Financing Does Not Come Cheap
- Mar 30, 2011
The structured financing market is showing signs of returning to life after two moribund years. But while the supply may be slowly reviving, high-leverage financing—which can bring leverage up to 85 percent, or even 90 percent—may still not be all that pervasive in the market.
As the economy and the apartment market recover, there may be less need for structured financing—in the form of mezzanine debt or preferred equity—to help rescue underwater or over-leveraged properties. “We do not see a great use of structured financing in the market,” agrees Craig Zimmerman, president of The Towbes Group Inc., a multi-housing developer, owner and manager opearting in the Santa Barbara and Ventura Counties, Calif. areas.
This form of financing does not come cheap today. Interest rates for mezz debt are about 9 percent to 11 percent for low leverage, and 10 percent to 15 percent for higher leverage, says Jason Choulochas, managing director, investments of Wrightwood Capital. For preferred equity, which demands both a coupon payment and equity participation, preferred rates are about 12 percent to 15 percent or higher, with a 20 percent to 50 percent profit participation, says Shlomi Ronen, managing director of Lucent Capital, a real estate investment banking intermediary that focuses on institutional transactions of $20 million or more. Target IRR yields for preferred equity are in the 18 percent to 25 percent range.
It is apparent that because of the high cost of such debt, only certain projects can effectively utilize the financing. “Structured financing, being the most risky piece of the capital stack that is subordinate to the senior mortgage, requires projects with a high level of returns, so that the most expensive pieces of the capital at the top of the stack can be adequately repaid,” says Zimmerman.
In this regard, while there may be fewer over-leveraged properties that have a need for mezz debt or preferred equity today, renovations in an improving economy may be a source of demand for this form of financing. Structured financing may be employed today especially for acquisitions and/or renovations projects that do not yet have income sufficient to support a GSE or CMBS loan. The financing is suitable especially for projects with some form of value-add component that can deliver the returns necessary to pay off the high-yield debt capital.
Zimmerman says, however, that it is difficult for the high leverage financing to fit in a marketplace in which there is already little room for further cap rate compressions. “When properties are trading at 6 percent cap, there is not a lot of yield left to pay that piece between 90 and 100 percent leverage.” The Towbes Group, incidentally, opts not to use this form of financing as it internally funds its projects, Zimmerman adds.
High-cost capital increases
While the demand for high-leverage capital may be limited, the supply of such financing in the form of mezzanine debt or preferred equity may be starting to open up and even become more competitive. Wrightwood Capital’s fund, High Yield Partners II, for example, is expected to increase its investments in joint venture equity, mezzanine debt and preferred equity this year, after relative inactivity from 2009 to 2010.
“Our partners are comfortable investing in multifamily again because they feel rents have bottomed and are on the rise, and there will be capital [to sell the assets] through Fannie Mae and Freddie Mac financing once the properties are turned around,” says Choulochas, adding that the $250 million fund, which closed in 2009, will be putting out about $125 million to $150 million this year.
Sources of mezz debt or preferred equity today are coming from fund managers, hedge funds, private equity funds and mortgage REITs. For Government Sponsored Entities (GSE)-financing, the mezzanine debt provider approved by Fannie Mae is RCG Longview, and providers approved by Freddie Mac are Waterton Capital Solutions, Berkshire Properties, Carmel Partners and Essex Properties.
The supply of high-yield debt is definitely below historical levels, however. A lot of the mezzanine debt or preferred equity capital that is returning to the market is capital that has already been raised in past years, rather than new capital or money originating from newly raised funds, says Choulochas. At this time, many institutional investors still want to allocate capital to core real estate rather than aggressive high-yield debt. Choulochas adds, “We think over time that will change.”
Fannie and Freddie furnish mezz programs
Another limit on the magnitude of demand for mezz debt results from the fact that Fannie Mae and Freddie Mac do not allow mezzanine financing to be placed on properties they finance, unless the capital comes from their pre-approved providers. And there has been very little activity in the GSEs’ mezz programs in the past few years.
Mezz debt offered through the GSEs’ approved providers are said to be pricey—the interest on the mezz portion can bite a chunk out of the cash flow. Borrowers may be wary of subscribing to the GSEs’ mezz programs because some of the providers are also developers and can assume their properties if they default on the mezzanine portion of the loans. Moreover, developers may have felt wary about opening their books to their peers.
Sue Blumberg, senior vice president and managing director in the Chicago office of NorthMarq Capital, says that under the GSEs’ mezzanine programs, the maximum LTV on the first loan will be 70-75 percent. And the maximum leverage on both the senior and mezz loans combined can be up to about 85 percent, as determined by the mezz provider. The mezz participants in the GSE programs are requiring IRRs in the high-teens, which translate into interest rates of 12 percent to 15 percent on the mezz piece. The borrower’s interest rate will be a blended rate of the mezz piece and the agency first mortgage, which is today about 5.5 percent.
Preferred equity sees increased demand
Blumberg says that many sponsors of Fannie Mae or Freddie Mac loans have simply opted for equity or preferred equity. Unlike mezz debt, preferred equity does not hold the partnership interests as collateral and cannot step into the sponsor’s shoes in the event of default. Instead, the investor contributes equity and becomes a partner, and the capital is considered senior to the other equity.
Fannie Mae and Freddie Mac allow preferred equity to be placed on properties financed by them, explains Blumberg. However, if the capital exceeds 25 percent ownership of the property, it is considered by the agencies to be preferred equity, and the capital provider will be subject to full approval by Fannie Mae or Freddie Mac. Blumberg says it is common to find properties financed by Fannie Mae or Freddie Mac to be carrying preferred equity, but a lot of them are “preferred equity at 24.99 percent.”
In possibly another boost to the utilization of preferred equity, some investment funds today are eschewing straight joint ventures in favor of preferred equity arrangements “to mitigate their downside risks in the deal,” says Ronen. Instead of providing 90 percent of the equity, the joint venture partner would provide less equity in order to have a lower basis in the asset. In return for its increased equity contribution, the sponsor would receive a greater piece of the back-end promote after the preferred equity source is paid its return of and return on investment.
In a recently quoted deal, says Ronen, a sponsor provided 20 percent of the equity. The arrangement allowed for the preferred equity investor to obtain its return of investment, and a 15 percent return after which the upside is split 50-50 with the sponsor.
Such structures are fairly risky for the sponsor because its return is subject to the return of, and return on, the investor’s equity before the sponsor gets its payback. “We try to alleviate that risk by structuring the transaction such that the sponsor obtains its return of capital before the fund gets its return on capital,” says Lucent Capital’s Ronen.
No doubt, the great benefit of structured financing is the high leverage that is offered. Mezz debt lenders can offer LTVs of as high as 90 percent, Ronen says. The minimum DSC ratio requirement for mezzanine debt is typically 1.10 for commercial and 1.05 for multifamily assets. Preferred equity can provide up to 98 percent of the capital stack, he adds. Terms today are generally three to seven years for mezzanine debt, as for preferred equity.
Countering the argument that there is little need for mezz cap today, Choulochas maintains that renovations are more feasible now that prospects are more willing to pay higher rents for better units. And, with the improving economy, developers are trying to spread their equity across more projects; as a result, they have a greater need for mezz debt or preferred equity. Additionally, there is still a great demand for financing the acquisition of distressed properties or notes, observes Ronen. And Christopher LaBianca, president of RCG Longview, says that there may be more mezzanine financing this year as maturing loans that may be over-leveraged, with as much as 90 percent LTV, come due.
However, it is not a cakewalk to obtain mezzanine or preferred equity. Mezzanine financing is by no means available to sponsors of underwater properties without some form of restructuring of the loan and an equity injection by the equity partners. Otherwise, the “structured capital will become underwater, too,” notes Zimmerman.
RCG Longview’s debt fund of about $600 million provides mezzanine debt, preferred equity and first mortgage bridge loans. Underwriting is based on current in-place cash flow and not pro forma, says LaBianca. The company seeks “established sponsorship with good business plans and track records,” and will consider secondary markets if “the operator is right and the property shows strong cash flow.” It would consider Class C properties on a selective basis if the plan is to renovate to Class B.
“A lot of money wants to be invested in multifamily,” says the Towbes Group’s Zimmerman, “but the challenge is to find good deals.”
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