In this summer of discontent for the commercial real estate marketplace, many investors are finding that their most difficult task is securing financing to purchase or refinance commercial properties. This is especially true for the relatively young or inexperienced developer.
There are, of course, traditional lenders such as commercial banks and insurance companies that will lend under new terms and conditions - leverage is no longer at 90% with interest only and little or no amortization. But representatives of these lenders have been appearing on my television show and at professional conferences to emphasize that their financing is available only to established, sound borrowers with whom they have maintained long-term relationships.
This presents a major dilemma for newcomers seeking to source capital. The answer for a growing number of these borrowers is alternative, or specialty, lenders that provide financing at higher rates and with stricter conditions.
"The conservative standards of insurance and commercial bank lenders result in a difficult plight for less established borrowers," a senior vice president at CB Richard Ellis, Enoch Lawrence, said. "One of the few alternative sources of capital for this type of borrower is the specialty lending community. The yield requirements tend to be much higher for these lenders, and as a result, there is more tolerance for less established borrowers with higher risk profiles."
Mr. Lawrence added that while it is easier for a less-established borrower to close a transaction with these specialty lenders, the economics of the loan must still be compelling. "Low loan-to-values and unusually attractive transaction dynamics provide moderation of risk and enough yield to support the higher-priced debt. As cap rates rise due to the current lending environment, more funds are being diverted towards opportunistic and value-add strategies. The specialty lending business is fertile ground for these redirected funds," he said.
There are many specialty lenders, including publicly traded BRT Realty Trust, CapitalSource, and iStar Financial, whose primary focus is on income-producing commercial properties that require immediate financing. Companies such as BRT can structure loans quickly, in as little as 48 hours.
"Alternative lenders are filling a significant void in liquidity in the real estate capital markets that has vanished due to the credit crunch," the founder and managing partner at Madison Realty Capital, Josh Zegen, said. He said his fund, with $250 million of institutional equity under management, "has seen volume of deals pick up in the last year as traditional lenders have pulled back in their willingness to lend. As a fund, we are not governed by regulatory agencies and are not subject to syndication or securitization markets so we can make quick decisions on the fly."
There are also a number of firms that have created funds to fill the void and take advantage of the distress in the market. They include Prudential Life Insurance Co. of America, which formed a joint venture with Carlton Advisory Services with $400 million of equity that will provide mezzanine financing for up to 85% of the capital structure for cash-flowing assets. Others include the Blackstone Group, Lone Star Funds, Highland Capital Partners, Rockpoint Group, the Carlyle Group, and a number of other sponsors, promoters, and opportunity funds that have either raised money or are scrambling to do so to provide borrowers with capital.
"Today's real estate lending markets are in upheaval and there seems to a snowball effect building," a principal at Ascent Real Estate Advisors, John Porges, said. "The commercial mortgage backed securities market for both fixed and floating rate debt has all but evaporated, not to mention the fact that the commercial debt obligation market is nonexistent. Special servicers in the structured finance area will be challenged by the increasing number of delinquent and maturing loans and previously active bridge and balance sheet lenders are going to be faced with extending maturity dates and limited capital availability. For those lenders that remain active, they are using the credit crunch as the justification for severely reducing proceeds, adding recourse, and ratcheting up spreads."
Mr. Porges added: "Companies like ours are actively seeking to fill a portion of the void that exists. We can utilize our expertise in construction and development to write sub-debt up to 65% to 75% of costs for those transactions having strong underwriting fundamentals. While some of our deals require partial or full recourse, it is not always essential."
An executive vice president at Rosenthal & Rosenthal, Sheldon Kaye, said: "Cash is king, and the only way to protect your cash and make it work for you is to be highly selective in this market. A lender must make sure that you know your borrower as well as the contractors they might be using if the project is for new construction. Private lenders like Rosenthal must know your exit strategy in case there is a default. In this market, if you are not in a position to take ownership of the real estate you might have second thoughts about lending."
A managing director at Hudson Realty Capital, Spencer Garfield, said that, "given the extreme lack of capital in the marketplace and the fact that the liquidity has been constrained for longer than anyone had initially imagined, there has been an increased roll of specialty lenders like Hudson Realty Capital. We are a real estate fund manager with over $2 billion in assets under management, providing debt and equity for special situation real estate transactions."
He added: "Specialty lenders will play a growing role in providing liquidity until such time as the conventional lenders regain their footing. Specialty lenders such as private equity and hedge funds have been very active in buying 'scratch and dent' debt, as well as distressed debt, from liquidity constrained conventional lenders. This, in turn, takes those assets off the conventional lenders' balance sheets, so that they will hopefully re-enter the marketplace. Within the last week alone, Hudson purchased a $15 million 'scratch and dent' whole loan and two non-performing loans totaling close to $17 million. Specialty lenders are also filling the gap in providing capital on transitional properties, properties in secondary markets, out of favor asset types, etc."
Madison's Mr. Zegen said: "Our company has seen borrowers today that would not have come to us a year ago because borrowers had so many choices. The market has shifted from a borrowers market to a lenders market with lenders offering much lower proceeds, sometimes as low as 50% loan-to-cost. We are helping to fill the void by sometimes lending at higher leverage points, given what we perceive as a good exposure.
"An example of this was an $18 million construction loan for a condo building that we closed on 82nd Street and Park Avenue in Manhattan. Although the borrower had purchased the land cheap - having rezoned the property during the course of the last year - most conventional lenders were offering a loan at 60% loan-to-cost, requiring the borrower to contribute significantly more equity than anticipated. Madison offered more proceeds than traditional lenders because we underwrote the loan amount of 65% of what we perceived the value to be, rather than on a loan-to-cost basis. Although our rate may have been higher than traditional savings banks, because we offered more proceeds our debt was cheaper for the borrower than if the borrower had to raise more equity. We are seeing many opportunities to provide financing like this to experienced borrowers where we can help them as a source of higher proceeds or quicker closings than traditional lenders," he said.
A principal at Palisades Financial, Mark Zurlini, said: "With the continuing deterioration in the real estate market we are concentrating on secured opportunities where we can secure first and second lien positions. In these times, we are highly selective, and the topic of ground-up development is not on our radar. We are seeking value added opportunities, such as existing retail centers, offices, or warehouses that are partially leased and require bridge financing for a period of one to three years. We will look at projects that are nearing completion, where the lender is fatigued with the project. In all these cases, the sponsorship is important. We want to be aligned with a seasoned owner-operator or developer. Additionally we look at what level we are lending. Obviously, the lower the breakeven point, the more attractive the deal. Consideration must be taken for the anticipated hold period and other soft costs. We require real equity - cash - in the range of 20% to 40%, depending on the project. Again, the wherewithal of the sponsor is paramount to doing the deal."
A partner at W Financial, David Heiden, said: "We have been seeing an increase in deal flow as more traditional lenders have pulled back. This is especially true for esoteric deals like financing for hotel, land, construction, and repositioning of properties. Over the past two years, we have seen an influx of what some may call hard-money lenders (specialty and alternative lenders). Most have been hedge funds and some are private equity funds. Recently we have seen several of these new lenders pull back from the market as they are now seeing defaults in their portfolio and need to focus on cleaning up their balance sheets."
The chairman of Carlton Advisory Services, Howard Michaels, said: "Most of the traditional lenders and bankers that borrowers used to be able to count on are not longer sitting in the same chairs: They are either shut down, or making plans to work elsewhere. All of this has created an environment where new lenders and new sources of capital have come into the market to fill the capital void, which previously had been supplied largely by Wall Street."
The bottom line is that borrowers made commitments over the past few years, which have resulted in their loans and obligations now coming due. The borrowers that need capital to refinance their loans and capital above 65% are having a hard time.
The accepted wisdom for borrowers is to try to find 65% to 70% loans for about a 6% interest rate, and then to identify capital up to 85% of the capital structure at a mid-teens cost. This will provide borrowers with a blended cost of about 7%. This capital cocktail is still economic and will help borrowers to get deals done. However, borrowers are not exactly clear on where this capital is available and that's where the role of savvy, sophisticated, "plugged in" intermediaries and brokers come into play, entities that can access this capital for proceeds-hungry borrowers.
Today, many individuals, hedge and private equity funds, and entrepreneurs seeking returns that range between 10% and 20%, coupled with origination fees, have entered the arena of alternative and specialty lenders. These lenders are not licensed and are working in an unregulated market, yet they fill a definite need for both inexperienced and experienced borrowers to gain access to mortgage financing. If a borrower is seeking financing from this type of lender, I concur with David Heiden when he says that a borrower should look for a lender with an excellent reputation, integrity, and reliability.