Upon the introduction in 2015 of new banking regulations related to holding extra reserves for short-term or riskier commercial real estate loans, banks reined in lending.
While the pullback affected property investors across the board, developers felt it most. Typical loan-to-cost ratios for construction financing dropped 20 percentage points to 55 percent, interest rates ballooned by some 150 basis points to around 350 basis points over 30-day LIBOR (London Interbank Offered Rate), and the number of banks that would consider development financing plunged, say mortgage bankers.
In 2017, the number of banks willing to look at potential deals grew and interest rates dropped some, but leverage generally remained capped at 65 percent of costs.
Consequently, borrowers more than ever are tapping non-bank lenders, particularly private debt funds.
“The most notable change in 2017 was the growth in debt fund activity,” says Kathy Farrell, head of commercial real estate for Atlanta-based SunTrust Banks. “They certainly stepped in to fill the gap in construction and acquisition financing created by the pullback of the banks.”
According to alternative asset research firm Preqin, 47 global real estate debt funds raised a record $28 billion in 2017, up from 32 funds that raised $19 billion in 2016. Debt fund sponsors include Brookfield Asset Management, Prime Finance, Blackstone and Oaktree Capital Management, to name a few.
Investors in the funds are aiming to protect downside risk in a peak-value property environment and are happy to reap yields of around 9 percent versus taking equity risk for higher returns, says Jonathan Lee, managing director for Los Angeles-based George Smith Partners. The firm expects to originate some $2.5 billion in financing this year, up from $2 billion in 2017.
Initially, however, debt funds were much more expensive than traditional lenders, typically charging interest rates of 350 to 500 basis points over LIBOR, says Wally Reid, a senior managing director with HFF in Houston. The added expense virtually shut down merchant building.
An extra 100 basis points on a $40 million construction loan adds another profit-eating $1.2 million in annual interest, he explains.
But over the last year, debt fund spreads over LIBOR have contracted by 100 to 150 basis points, says Bruce Francis, vice chairman of CBRE Capital Markets.
Among other deals, at year-end Francis was arranging financing for a non-institutional, value-add office buyer in Phoenix through a debt fund, which was providing a 70 percent loan-to-value ratio and an interest rate of 300 basis points over LIBOR.
“We’ve seen so many additional entrants into that market, and I think to a large extent the funds will remain a big story in 2018,” Francis notes.
In addition to debt funds, foreign capital has also closed some financing gaps left by banks. In July, George Smith Partners tapped an offshore investor for $21.6 million in non-recourse financing to develop a 35-unit condominium project with ground-floor retail in the Silver Lake neighborhood of Los Angeles.
The borrower received 80 percent of the cost of the project in a two-year loan with an interest rate of 10 percent.
“Even with condo construction default liability of 10 years in California, the fact that units are coming out of the ground shows that there’s demand for the product,” says Lee.
— Joe Gose
This article originally appeared in the February 2018 issue of Heartland Real Estate Business.