by Patrick O'Donnell
There is no such thing as a “plain vanilla” real estate development. Each project comes with its own unique set of challenges that require diligent planning, creativity, and resolve. Financing a completed project is no different, as refinancing decisions can have as great an impact on a project’s profitability as the most critical decisions during the construction phase. For EB-5 developers that intend to continue owning their projects upon completion, this article provides a general overview of commercial real estate lending markets, complete with refinancing frameworks to help developer-owners protect the value they have created.
Three Common (But Avoidable) Mistakes
Before diving into specific features of commercial real estate (“CRE”) lending markets, it is helpful to understand three of the most prevalent mistakes that borrowers make when refinancing debt.
1. Failing to match financing strategy with asset strategy
Every borrower focuses on the proposed loan proceeds and interest rate when evaluating refinancing alternatives, but there are many other structural features that have a meaningful impact on returns and risk mitigation. When developers fail to appreciate the implications of these loan features, the consequences can destroy equity value.
For example, mismatching the financing term with the property’s average lease term can destroy value even if the property preforms well. Imagine a recently completed Class A office building that has just inked two investment-grade anchor tenants to 20-year leases. The developer decides to replace the construction loan with a five-year permanent loan from the existing lender, because the lender offered an attractive rate and was a good partner during the construction phase. This may sound like a positive string of events, but the term mismatch has introduced substantial risk to the property. Interest rates are at historical lows and could be substantially higher when the 5-year loan matures, yet the property cash flows are fixed via the 20-year leases. In the best-case scenario, profitability will have eroded; introduce inflation or increasing cap rates, and the developer may have to contribute new equity in order to refinance.
In addition to average lease term, a comprehensive refinancing strategy incorporates the property cash flow profile, planned hold period, partnership needs, portfolio composition and tax considerations. These factors inform loan features such as financing term, fixed vs. floating, hedging decisions, prepayment flexibility, leverage target, reserve requirements, and transfer conditions.
Borrowers achieve better outcomes when they have spent time contemplating structural options prior to soliciting lender proposals. An effective approach is to determine a few critical structural features in advance and ask lenders to provide feedback on a few others. This puts the borrower in a position to price tradeoffs and optimize the loan across pricing, leverage and structure.
2. Time mismanagement
The refinancing timeline can be driven by EB-5 loan maturity, construction loan maturity, preferred equity redemption date, or I-829 approval, among other factors.. It is never too early to begin evaluating alternatives, especially when considering a sale of all or part of the project upon completion. Critical early steps are to identify the timeframe when new capital is needed, and to understand the implications, if any, of prepaying the existing debt.
Once a lender is chosen, CRE loans usually close within two to three months, but unforeseen delays are not uncommon. Additional time is warranted for highly-leveraged loans, senior-mezzanine structures, or situations where the developer is depending on new partner equity to close. Developer-owners should do everything possible to synchronize construction loan refinancing with the return of EB-5 investor capital. Financing options will be significantly constrained if the new lender has to share collateral with EB-5 investors, and additional time should be budgeted for situations where that is a possibility.
One last note on timing – lenders do not respond well to last-minute surprises. If a borrower anticipates property-specific challenges or loan-specific complications that may threaten the ability to refinance at loan maturity, it is generally advisable to notify the existing lender early on in the process. Early lender involvement tends to build good will and trust, leading to better, more rational outcomes.
3. Recourse redux
CRE development is not for the faint of heart, and the risk of property-level losses is part and parcel to owning real estate through economic cycles. However, the risk of losing personal assets through recourse provisions should be avoided when possible, and all borrowers refinancing a completed construction project should place a high priority on obtaining non-recourse financing. While partial or full recourse has been a standard provision for construction loans originated since the start of the recession, non-recourse financing is often available upon project stabilization. For situations where partial recourse is unavoidable upon refinancing, developer-owners should work to negotiate “burn-off” provisions that scale back the recourse requirements as the property achieves performance thresholds.
These are just a handful of the most common mistakes borrowers make, regardless of whether there is EB-5 capital in the project. On occasion, even seasoned CRE developers and owners fall victim to the missteps highlighted above. Situational specifics may vary, but lack of capital markets awareness is almost always a contributing factor. Many borrowers simply do not have the time and expertise to assess the full range of financing options available when it is time to refinance. The following market overview is intended to broaden borrower awareness of common features of CRE debt capital markets.
Overview of CRE Lending Markets
This capital markets overview is a generalization of terms and conditions observed in each lending market. Not every description characterized herein is true of every lender in each category. It is always a good idea to solicit feedback from lenders in multiple lending markets to confirm current market features and achieve optimal execution.
This summary covers the three traditional CRE mortgage lending markets, commercial banks, CMBS and insurance companies, as well as agency lenders and non-traditional high yield options.
Commercial banks come in all shapes and sizes, from local community banks to multinational conglomerates. Most construction lending in the United States is originated by commercial banks, as they specialize in borrower credit analysis and administering loans over a development timeline. Commercial banks take a comprehensive view on profitability, and can offer better loan terms to borrowers that use other bank products and services or hold substantial deposits at the bank.
The structural features of commercial bank loans are well suited for borrowers that desire the flexibility to sell or refinance the property in the near-to-intermediate term. Initial terms are typically between two to five years, and it is normal to have a predetermined number of extension options at the borrowers’ election, subject to agreed-upon extension tests. Bank loans are usually floating rate, and it is common for banks to require the borrower to hedge their floating rate exposure through interest rate derivatives. Banks charge an upfront fee and extension fees in order to improve the loan yield, and there is often a lock-out period wherein prepayment is prohibited. Once past the lock-out, the primary prepayment cost for most loans is the termination cost of any outstanding interest rate derivatives. Local banks and smaller regional banks are much more likely to require recourse provisions.
Commercial mortgage-backed securities
The commercial mortgage-backed securities (“CMBS”) conduit market originates and packages pools of mortgages that are rated and sold to fixed income investors. CMBS rates and terms are typically more volatile than other CRE lending alternatives because origination is often directly impacted by the fixed income market. Buyers of CMBS are looking for stabilized cash flow, so construction loans and transitional properties are not well suited for conduits. However, stabilized properties located in secondary and tertiary markets benefit from the value that rating agency models place on geographic diversification.
Borrowers seeking to optimize interest rate and proceeds over a longer-term hold period may be well suited for CMBS. Fixed rate, 10-year loans are most common, representing approximately 8 percent of all U.S. conduit loans in 2014. Other term lengths are possible, though pricing is most efficient at the 10-year point. Floating rate options are occasionally available, subject to market demand. CMBS loans are pre-payable subject to the cost of defeasance, which can be expensive if interest rates are low, or if there are several years until the loan matures. Underwriting fees are moderate relative to commercial bank fees. In general, CMBS terms are less flexible than those of other lending markets because fixed income investors favor consistent structuring.
Insurance companies and pension funds
As a group, insurance companies and pension funds are the most conservative CRE loan originators, evidenced by their relative health and growth in market share during the recent recession. These are yield-driven investors with a mandate to originate safe long-term loans to match against long-term balance sheet liabilities. In low-rate environments Insurance and pension lenders often insert yield floors to ensure acceptable returns on their originations.
Insurance and pension lenders are a good match for borrowers targeting moderate-to-low leverage. For trophy assets with moderate leverage, these lenders can offer unparalleled structural flexibility. Loan terms span from 5 to 30 years, and are commonly in the 7 to 12 year range. Fixed rate is more common than floating, as insurance and pension lenders have a fixed liability profile. Loans come with a variety of prepayment structures, including yield maintenance, defeasance, and percent of principal. Underwriting fees are moderate and in line with CMBS fees.
Residential owners exploring refinancing options should consider agency alternatives. Properties that contain a residential component may qualify for agency lending programs offered through Freddie Mac, Fannie Mae, and Ginnie Mae lenders that are authorized to underwrite agency loans. Program options vary in term, rate, leverage, and fixed/floating designation, and are too numerous to detail here.
Debt funds, bridge lenders, and other non-traditional alternatives
This catch-all category of lenders is populated by yield-driven investors seeking higher returns than those offered by investing in low-leverage, stabilized mortgages. These lenders often face significantly lighter regulation than other lending markets, enabling ultimate structural flexibility and creativity. Non-traditional lenders are more comfortable employing “loan-to-own” strategies than their traditional lending counterparts, and borrowers must be especially mindful of default provisions when negotiating with high-yield lenders.
Developments with EB-5 capital structured as mezzanine debt or preferred equity are more likely to require high-yield capital to successfully refinance. This may come in the form of short-term bridge financing, longer-term subordinate capital, or a single high-leverage mortgage. Loans tend to be shorter term and include relatively high yields and fees. Many non-traditional lenders take an absolute-dollar perspective and are willing to trade off structural flexibility, interest rate, and fees (origination fees, extension fees, exit fees) so long as the expected dollar return is constant.
Developer-owners can mitigate risks and protect their property equity by applying the same diligence to refinancing as they do to the development process. This is particularly relevant for EB-5 developers, as they must address capital staging challenges and frequently have high-leverage projects to refinance. Fortunately, there are unprecedented levels of liquidity in the CRE debt and equity markets right now. EB-5 developers that get an early start on the financing process and are thoughtful about their loan structure have an excellent chance of achieving an optimal financing structure that sets the stage for the next phase of ownership.