By David DiRienzo, director — business development, at Talonvest Capital, Inc.
This is part one of a two-part series discussing the key drivers behind transaction volume and the steps owners can take to ensure they are well-positioned going forward.
Much has been written about the decline in transaction volumes over the last 24 months. There is no question that properties are changing hands at a slower pace compared to the activity seen during the low interest rate environment that prevailed during the pandemic. Even so, many investors continue to seek out financing to address a variety of circumstances.
In today’s market, beyond simply refinancing due to an upcoming loan maturity, three scenarios have been driving financing activity among owners of self-storage, multifamily and industrial assets: restructuring debt as a project evolves, elective refinancing to improve performance and capitalizing on a new business plan. We will cover the first theme below in part one of this two-part series.
Business Plan Progression Offers Opportunities for Owners to Unlock Value
As a business plan evolves and the asset matures, it’s beneficial for owners to reassess their capital stack to optimize investment performance and maximize their goals. Completing a refinance at a natural project inflection point can afford owners with liquidity the latitude to expand their portfolio or complete capital improvements, improve investor economics, hold cash on the books or simply optimize the capital stack for the project.
One of the interesting dynamics in commercial real estate financing is that lenders tend to specialize in underwriting loan products for a particular stage in the business plan or asset lifecycle. Borrowers should be aware of the risk that their current lender may not be best suited to continue supporting a transitional business plan.
Depending on the lender’s particular circumstances, they may have limited capacity to extend additional financing as the asset matures, or they may not be equipped to offer the best terms. Owners should understand the limits of their current lender’s underwriting capabilities and be aware that it is possible to outgrow the current lender as the business plan progresses. Three common scenarios demonstrate this:
1. Construction To Bridge: Positioning for Future Value Creation
Owners seeking to transition from construction to bridge loans often find their current lender ill-suited to support the refinance. Lenders that specialize in construction loans are rarely the same ones that offer the most advantageous bridge debt. A construction loan specialist may offer bridge products, but they tend to be more expensive, require recourse, require amortizing payments and may not provide enough additional leverage to meet the owner’s needs. Unfortunately, many owners do not realize this or only begin to explore alternatives late in the process, which can add pressure to the project.
When moving from a construction to bridge execution, borrowers should gauge the amount of risk remaining in the business plan. From a bridge lender’s perspective, it is important to evaluate the amount of cash flow the project is producing today, the relative in-place loan metrics and the projected asset performance. Borrowers must be prepared to navigate lender scrutiny and answer these considerations during the lender’s approval process.
2. Reserve Replenishment: Creating Liquidity to Maximize Outcomes
As interest rates moved higher in the post-pandemic environment, many owners struggled with depleted operating reserves under an existing loan. Refinancing can be a useful tool for replenishing reserves because taking out the existing loan with a new one often allows for the establishment of a new reserve, which the owner can draw on over time to fund expenses.
Owners who face a reserve shortfall and opt not to refinance, or begin the refinancing process too late, are often left with unattractive alternatives. These could include operating the property at below-peak income levels, personally contributing equity to the deal, asking investors to fund a capital call or exploring potentially expensive mezzanine financing. Fortunately, many owners have succeeded in refinancing into bridge loans to replenish reserves and avoid the need to inject fresh equity to carry the project.
3. Post-Stabilization Risk Reduction Using Permanent Loans
Once an asset is stabilized, owners typically explore ways to de-risk or optimize the capital stack. For stabilized assets with steady cash flow, this may involve taking advantage of a long-term, fixed-rate loan because these products are usually offered at the lowest interest rates and eliminate the risk associated with a floating rate. Furthermore, most stabilized loans are non-recourse, helping borrowers reduce any contingent liabilities they may have from construction or bridge loans on the property prior to stabilization.
While fixed-rate permanent loans may seem straightforward on the surface, lenders offer a wide variety of structures, and this can have a dramatic impact on the economics of an investment. Sourcing the right lender and negotiating key terms such as the loan size, pricing and prepayment penalty can be a determining factor in overall project performance.
Additionally, many lenders in recent years have expanded the metrics used for loan sizing beyond loan-to-value (LTV) to include debt service coverage ratios (DSCR) and debt yields. Considering this added complexity, it is important for real estate investors to prepare a financing strategy in advance of identifying potential debt solutions. This can be achieved by understanding the key risk points in a loan request, obtaining the data necessary to support owner projections and gauging how aggressive to be when negotiating loan terms with the lender.
How a Capital Expert Can Help Owners Navigate Today’s Financing Market
Obtaining financing in today’s market can be challenging because every owner faces a unique situation, and a positive outcome often requires a tailored loan structure balancing tolerance for risk and uncertainty with the opportunity to earn a return. Furthermore, lending programs are evolving rapidly, and identifying the best lender or product for a given situation can be difficult.
Against this backdrop, working with a capital expert is an important step for an owner to take because it greatly increases the chances of a positive outcome. In recent months, the team of capital experts at Talonvest has secured financing for commercial real estate owners facing a variety of situations. During this period, owners presented unique business plans, and the assets involved were at different lifecycle stages. Here are a few highlights:
Leaning into Our Lender Network to Help a Private Investment Firm
Talonvest recently leveraged a deep roster of lenders to secure a fixed-rate permanent loan for a private investment firm that had a project approaching stabilization. We ran a competitive bidding process among several groups (life companies, CMBS, banks, private lenders, etc.) and secured the best combination of terms and pricing for our client, including full-term, interest-only financing at a low price. We also secured a rate lock at application, sixty days before closing — during a period when interest rates were on the rise. This strategy resulted in significant savings for our client.
Relieving an Owner from an Insufficient Interest Reserve
A client had a construction loan coming due and exhausted the interest reserve after an unprecedented interest rate increase stemming from post-COVID monetary tightening. We were able to secure a new bridge loan, including fresh reserves funded by the lender, and this positioned our client to focus on executing the business plan. As a bonus, the loan also included an earn-out that offers an opportunity to recapture some of the invested equity once the property stabilizes.
Navigating a Complex Refinance to Avoid an Equity Infusion
Even though interest rates were not declining, Talonvest helped one client achieve a cash-neutral refinance that would have otherwise required an equity contribution at closing. This was done through the purchase of an in-the-money interest rate cap that effectively lowered the overall interest expense throughout the loan term and subsequently improved the project’s DSCR to the lender’s satisfaction.
Stay tuned for part two of this series, which will focus on elective refinances and financing new business plans.
David DiRienzo, director — business development, at Talonvest Capital, Inc. is responsible for sourcing clients and developing new business opportunities. His commercial real estate experience includes over $1.5 billion of closed financing transactions and over $250 million of asset acquisitions during his six years working on the principal side of the business. David can be reached by email at ddirienzo@talonvest.com.
Talonvest Capital, Inc. is a content partner of REBusinessOnline.