By Scott Lynn 

As the CRE capital markets have moved into recovery mode, Borrowers are doing what they always do, pushing Lenders higher up the leverage curve.

Likewise, Lenders are responding with creative capital structures that provide the lure of leverage while trying to figure out how to get adequately compensated for the extra “risk adjustment.”

Some deals are being structured as “Participating Debt” where the capital provider not only makes a loan with an agreed-to interest rate but also participates in a percentage of the project/property operating cash flow and/or sale/refinance proceeds. The attraction to the lender is that yields can be significantly enhanced by receiving a piece of the potential future cash flow.

participating debtWhy would a Borrower/Sponsor think about giving up a piece of the upside to the Lender? Because the Lender has essentially become a new partner (or an additional partner, as the case may be) in exchange for providing higher leverage, sometimes into the highest stratosphere of the capital stack. In fact, the use of leverage can actually lower a real estate sponsor’s overall cost of capital in comparison to more conventional debt/equity mix.

Our firm recently received a debt proposal to provide 90% loan-to-cost construction financing for a branded hotel project that included participation in property cash and sale proceeds with a five-year build/stabilize and sale horizon. We compared the developer’s average cost of capital along with the return on equity under the proposed 90% participating debt structure to a 65% conventional construction loan. Even after accounting for the Lender’s participation in the cash flow and project profit, not only was the sponsor’s overall cost of capital lower with the use of participating debt but the equity returns were substantially enhanced. Moreover, the sponsor had to raise less than a third of the equity under the participating debt scenario.

Simply stated, the cost of the extra debt vis-a-vis giving up a portion of equity participation in your deal may very well be worth the extra leverage and enhanced equity returns because of the use of additional leverage when compared to a conventional alternative.

A participating debt structure may not always be a good fit given the situational dynamics of the transaction.

When a particular deal has a long-term business plan, the use of participating debt may not be appropriate given that IRR’s diminish over time. If the deal takes too long to produce the “POP,” a participating debt provider’s return may not come soon enough to meet its investment objectives. Worse yet, time increases the effect of “negative leverage,” when a deal fails to produce the minimum interest rate return for the participating lender and the borrower runs the risk of having to write a check just to get the Lender paid off. A land development is likely NOT the best fit for participating debt structure, but a shopping center renovation that can maintain enough property cash flow to pay debt service current probably IS.

Participating debt players in the CRE capital markets jungle are not always easy to spot. First, they are usually not the conventional local, regional, or national banks. More likely they are private book lenders, newly-formed FUNDS, or private REITs or non-regulated lenders, such as insurance companies or pension fund advisors. In some cases they are large institutional equity investors that have figured out how to leverage their balance sheets by using their own underlying debt while offering the Borrower a one-stop, high-leverage execution.

No matter who is providing the money, these are sophisticated investors that ask questions that are focused on the equity risk as much as they are on the debt risk… as it should be. After all, the participating debt player is essentially providing a crucial piece of the equity stack via the debt structure. No doubt these deal structures require detailed analysis, careful negotiation, and expert documentation. The devil will always end up in the details.

For further information on participating debt, mezzanine, or a preferred equity structure for your commercial real estate acquisition or development, contact any one of our MCA Senior Directors by visiting our website at