by Gabe Gonzalez
The process of obtaining capital can prove challenging and time-consuming regardless of whether it is a simple refinance or persuading an equity source on the viability of a new ground-up project. Since joining MCA, a commercial real estate finance intermediary, I have had the opportunity to work on a myriad of deals ranging in size and complexity. Every transaction will have a bump along the way; however, it appears that most bumps happen to be reoccurring issues that typically can be addressed before a problem arises. Most of these issues stem from misconceptions, assumptions, expectations and small errors that can be vetted and addressed well before the transaction ends up on the desk of a capital provider. Below are some issues that sponsors / developers encounter as they try to obtain capital.
The capital markets have recently enjoyed an increase in the number of banks promoting non-recourse loans for qualified sponsors. Agency loans remain the most sought-after vehicle for financing multifamily transactions due to their low interest rates and non-recourse loans. The typical misconception about non-recourse loans is that the credit of the borrower is irrelevant since the lender can’t go after the borrower’s personal assets. In reality, the amount of credit-related items required for non-recourse loans are just as in-depth as a recourse loan. On a non-recourse loan, the only collateral is the property, so the lender wants to make sure the borrower has the financial wherewithal to keep the property afloat and in good condition during an economic downtown. Since the lender cannot go after personal assets, they need reassurance that the principals have sufficient resources to feed the property if necessary, which explains more in-depth disclosure requirements.
In the past, a borrower was typically asked to provide just a simple financial statement along with a credit check, and that was the extent of the credit items required. In today’s environment, all lenders will require an extensive amount of credit due diligence, regardless if the loan is guaranteed. Be prepared to provide actual bank statements to verify liquidity (6 months of debt service), an up-to-date global cash flow or real estate owned schedule, and a summary of any contingent liabilities. A borrower should disclose their contingent liabilities / REO schedule to their mortgage broker prior to signing up with a lender. Typical issues that arise on an REO schedule are the overall leverage of the portfolio, the value/cap rate placed on each asset, nearing and/or concentrated maturities, properties operating under a 1.20x DSC, the number of recourse loans, and land that is encumbered. MCA has a long list of lenders with varying risk appetites; therefore, disclosing issues at the beginning will help MCA better direct the deal to the appropriate lender.
DPOs and Cost Basis
If you are considering purchasing your existing mortgage at a discount, executing a short sale or a lender has offered you a discounted payoff (i.e. DPO), pay close attention to the overall basis as the new lender will most likely not fund 100 percent of the discounted note, even if the appraised value is higher. The lender feels more comfortable when new fresh equity is injected so that the sponsor has “skin in the game.”
Read the Term Sheet & Application
Whether its cash flow sweeps, reserves or investment hurdles, it is imperative to understand the loan application / term sheet. Capital providers become frustrated when sponsors and their legal counsel voice issues at the closing table after the requirements were mentioned within the application. The sponsor should carefully read and make a list of all the issues/questions before the application is signed. The back and forth “Shuttle Negotiating” may be necessary in order to get an absolute clear understanding and agreement to all the pertinent business issues. Extra upfront efforts will avoid hassles and headaches later in the closing process.
Time Kills Deals
Time is one of the biggest factors that can kill a deal. Lengthy negotiations, unresponsive partners and/or third parties (i.e. appraisers, engineers, and environmentalists) can lead to unanticipated delays. While some delays are uncontrollable, obtaining capital for a transaction needs to be the top priority for any sponsor.
With smartphones and online file sharing, the process of obtaining due diligence items is now instantaneous. No longer does one have to Fed Ex huge reports or wait for the next business day for a response. Providing the requested information in a timely manner and being responsive shows the capital provider that the sponsor is serious. Underwriters tend to prioritize their deals based on movement, so prolonging a deal is a sure way to be moved to the bottom of the stack.
The longer a transaction takes to close, the more a deal is prone to uncontrollable factors, such as interest rate risk. Moreover, prolonging a deal allows the most detail-oriented lender to leave no stone unturned. Equity providers are constantly solicited deals to invest in, so their attention span is short lived as they need to place their capital quickly.
To ensure the certainty of execution, the sponsor needs to begin preparing prior to engaging the capital source by notifying all related partners and management that any information and requests need to be addressed in a timely manner.
As local municipalities begin to recover from the recession and benefit from increased tax revenues, the focus on redeveloping certain areas has increased. TIFs are a public source of financing that is used to subsidize development and infrastructure, and is paid for by future gains in tax revenues from the surrounding development. While TIF money is an excellent way to make a development a viable investment, rarely is it paid up front. Each district has different structures in how and when funding occurs. Moreover, there are varying methods that are used for monetizing TIF payments, such as taking the net present value of future TIF payments; therefore, careful analysis is required. The biggest mistake developers make is to assume that the TIF money will be paid at closing and can be used as equity. Even if the municipality agrees to fund 15 percent of the construction cost, it most likely won’t be paid until tax revenues are generated in the future, so rarely are TIF payments used in the initial equity equation.
Soft costs are typically full of fees and due diligence costs; however, other expense line items such as interest rate carry, tax/insurance escrow, and contingencies are sometimes overlooked as they are not expenses directly related to the construction. A draw schedule is a great way to estimate how much interest will be paid on the outstanding debt. For the back-of-the-napkin budget, a conservative estimate is to assume seven (7) months of debt service from the total debt. In many instances, developments rarely finish on time or on budget, so it’s safe to place a 5 percent hard cost and soft cost contingency, unless a contractor has provided a guaranteed maximum price.
Free & Clear Yield on Cash
MCA continues to see a multitude of proposed Garden-style apartment developments, due to strong apartment market fundamentals. Calculating the unlevered yield of a proposed development is a quick litmus test to see if the project is viable. Unfortunately, most developments are “no-goes” because the yield is too low. The yield is calculated by taking the Stabilized NOI / Total Cost. Generally speaking, a project needs to have 175bps to 200 bps spread between the going in unlevered yield and the exit cap rate that is projected to adequately allow for market fluctuations while under construction and lease up. If the spread is less than 150 bps, an investor would come to the conclusion that there is not enough profit in the deal to justify the construction risk. Most people think that when interest rates rise, cap rates will follow. An urban apartment located at Main & Main can justify a smaller spread since the cost of land is higher and the likelihood of the cap rate rising is lower.
Underwriting issues are never-ending. The best way to get your deal to the finish line is to use an experienced intermediary who has the market knowledge to anticipate a solution before the problem arises. Metropolitan Capital Advisors has the deep rooted relationships and transaction experience to significantly increase the probability of a successful closing.