By John Garrett of Enterprise Bank & Trust
Driven by an ongoing shift in demand and industry-specific needs from commercial real estate space, adaptive reuse projects can transform existing underutilized buildings into new and more functional spaces. Offices and retail properties can be reimagined for shared or added functionality, or in some cases, reconfigured for entirely different purposes, including residential use.
These projects allow developers to capitalize on opportunistic investment into value-add acquisitions, as well as tenant-driven opportunities.
However, the size of these transitional, sub-institutional development projects creates a unique financial challenge. Many traditional lenders see these as too small and risky, with an aversion to arranging moving pieces to creatively manage tailored financing solutions that are needed to acquire and alter spaces for new opportunities.
Transitional development projects don’t involve stabilized properties. Instead, the opportunity lies in repositioning the space to add value, which often means limited cash flow for an interim period while needing immediate access to funds.
Creating efficient and flexible banking partnerships can allow real estate developers that are interested in pursuing these projects to scale business in a manner that helps meet a growing demand.
How Lending Can Differ
Both the complexity and varying size of the transactions create challenges in terms of finding strong and willing long-term financial partners, especially given the limited number of knowledgeable lenders specializing in this niche space.
However, record amounts of underutilized, distressed or aged commercial real estate have been transformed into higher-value, modernized or repurposed spaces. These projects are often driven by local developers or specialized investment firms targeting tertiary or distressed markets or specific infill opportunities, bridging the gap between small local projects and large-scale institutional developments.
This can be especially true in municipalities that offer incentives like tax abatements, which create an extra layer of nuance to lending needs.
Transitional property developers often leverage local banks with professionals who are able to facilitate opportunities that larger institutional players might overlook, while also benefiting from faster timelines and less competition. But along with being risk averse, banks are also highly regulated, which can set the stage for disconnect when developers bring innovative new ideas to the table.
Upfront understanding of these differences helps better prepare developers and borrowers to be “loan ready” and minimize miscommunications in the lending process, especially when balancing between both expected and unexpected opportunities.
Minimizing Obstacles
The current economic environment includes unique challenges for securing debt and equity in addition to persistent issues, such as rising costs, labor shortages and occasionally lengthy lead times for essential materials. Adding in compliance hurdles, such as zoning and environmental regulations, further intensifies the need for access to capital and strong collaboration with local planners and experts.
While some criteria weigh heavier than others, ensuring that crucial aspects of the financial picture are in good shape will help create a better position when loan decisions are made in tight windows. Here are six common loan stumbling blocks to avoid:
Lack of experience: Some developers do not have the experience in converting and/or changing the use of obsolete buildings into new functional buildings, so planning and budget factors may be under increased scrutiny to determine preparedness.
Minimal understanding of numbers: Without a strong understanding of the market, or with failure to determine what a property will demand in rents or with underestimation of expenses or reserves needed, the developer and the bank are vulnerable should any financial challenges arise.
Interest rates as the primary concern: Everyone wants the lowest possible interest rate. But if a developer is talking with five to six prospective banks, that may be viewed as “rate shopping” rather than seeking a business partnership. Switching banks frequently also leads to questions about commitment.
Excessive dependencies: There is risk in being overly reliant on factors like a key raw material, one or two huge customers or a labor contract. High dependence on one or more components of the business plan puts the developer at greater risk for sudden failure in a project. The banking advisor should seek to understand these dependencies and ideally help identify ways to minimize that risk.
Lack of equity: If an entrepreneur or small business owner hasn’t put his or her money in or at risk, why should the bank?
Growth and expansion that is too fast: This may seem counterintuitive, but rapid expansion or too many projects at once can mean that management may not be able to sustain that growth, maintain focus on the project or may not have grown its internal infrastructure or capital base to keep up.
Position for Opportunity
Sub-institutional, transitional development projects typically focus on value-add or other opportunistic strategies, which frequently involve upgrading physical structures, improving management or changing the use of the building.
The impact on efficiency is perhaps the greatest part of having a long-term, go-to lending partner that understands the nuances of the timelines and challenges involved with making them successful.
The trend in converting older, inefficient or vacant properties — particularly office buildings — into residential, mixed-use or modern workplaces shows no signs of slowing. This is especially true in niche sectors where focus often shifts toward alternative property types that provide higher yields and stability or where new construction is cost prohibitive. This includes self-storage, medical office buildings, student housing, multifamily and even data centers.
Collaborating with a team of professionals invested in the value-add nature of the transactions becomes essential to navigating the moving pieces and varied lending structures to push projects across the finish line. Finding financial partners that don’t have to be educated on the how and why adds to the value while creating a symbiotic and mutual benefit for both teams.
John Garrett is senior vice president, director commercial real estate at Enterprise Bank & Trust in St. Louis. He leads a team of banking professionals with expertise in commercial real estate finance, growth and strategy.