COVER STORY, FEBRUARY 2007

NORTHEAST BANKS & LENDING

This month, Northeast Real Estate Business asked several financial experts to contribute articles about important lending issues in the commercial real estate industry throughout the Northeast. 

Changes in 2007 Real Estate Market Fuel Demand for Short-Term Financing

With the national market in transition, property owners seeking financing in 2007 will experience significant changes in the real estate lending environment.  

Any projection about the economy and real estate has to begin with the spending confidence of the American consumer which, in recent years, has been closely aligned with rising home values. Beginning in 2006, a convergence of economic conditions — rising interest rates, higher energy costs and a softening of the residential market — began an erosion in that confidence. Now, home values, a key driver for the broader economy, are falling in many markets, with predictions of 12 to 18 months before improvements in current conditions.   

With home owners accustomed to double digit increases, quickly rising equity, lavishing money on homes and trading up, the residential market decline has caused a ripple effect. Commercial real estate borrowers will find traditional lending institutions have manifested their concern about a slowing economy by becoming more conservative, tightening loan criteria and credit lines and seeking to divest certain types of existing lending products.  

Though traditional lenders have become more risk adverse, 2007 will be rife with real estate opportunities for investors and purchasers of commercial real estate, many of whom will turn to unconventional or short-term lenders to get a deal done quickly and efficiently.  

In every type of market, there are numerous real estate scenarios where short-term financing is an ideal financial solution, among them the need to quickly refinance to buy out of a troublesome partnership; renovate or reposition a property to attract higher quality tenants and rents; stave off foreclosure or bankruptcy; refinance high interest rate mezzanine loans; and obtain fast financing for a time-sensitive acquisition. Or, perhaps a property needs mold remediation, is vacant or has another atypical condition which makes obtaining traditional financing difficult, if not impossible.

Unconventional lenders have always been a resource for borrowers unwilling to deal with the lengthy time frames and red tape that is common with traditional lending institutions, or who are unable to meet stricter underwriting standards.  

Market conditions in 2007, however, are fueling greater demand for short-term finance transactions. There will be more properties under duress; more properties languishing on the market seeking buyers for longer periods of time; more note repurchases or buying back debt at discount; more banks seeking to get out of unsold share transactions with remaining apartment inventory; and less available financing for conversion deals as the condominium market appreciably slows.  

Short-term lenders, which specialize in finding finance solutions for problematic situations, will fill the breach. At BRT Realty Trust, property owners can seek a loan-to-value of up to 85 to 90 percent, dependent upon other collateral, on loans ranging from $1 million to $75 million. Though lenders will allow equity cash-out, the preference is to have the borrower retain an equity position in the property to avoid overleveraging and sustain financial interest.  

The opportunity to purchase properties less expensively than in recent years will motivate investors and purchasers, as well as entice more new buyers into the market. With many of these time-sensitive acquisitions, the flexibility and speed with which short-term lenders operate are invaluable in locking up a good deal quickly. Though there are borrowers who view working with short-term lenders as a resource only when they find themselves in unusual circumstances or under financial duress, the need for speed is one of the most compelling drivers of working with a short-term lender. At BRT, many of our customers are financially sound, but simply want and/or need to get a transaction done quickly to capitalize on an opportunity.  

In the retail commercial sector, one timeline looming for the Northeast is the large number of loans coming due or being extended (on new terms with higher interest rates) from 5 and 10 years ago, as well as the increased stress on the cash flow of owners locked into leases as the cost of money rises. As consumer spending dwindles concurrent with falling home values, more owners of aging retail properties will be looking to refinance to fund improvements and stay competitive. We expect to see an increasing number of acquisitions of mismanaged properties in tandem with cosmetic improvements and market repositioning, which is one of BRT’s, as well as other short-term lenders’, products.  

One previously super-hot market segment that has experienced  significant cooling is condominium conversion. As banks seek to get out of remaining inventory, BRT is seeing many more unsold share transactions/refinances. With units taking longer to sell, borrowers have considerably more flexibility when working with a short-term lender to affect a  price reduction strategy when banks with a lien on a property will often disallow 10 to 15 percent reductions in release prices.  

A $27.25 million acquisition and pre-construction loan recently closed by BRT is an example of a property that benefited from the flexibility and speed inherent in working with a short-term lender.  

The property, a six-story, 45,000-square-foot building is in the heart of SoHo, one of  Manhattan, New York City’s, most sought after and priciest neighborhoods. The borrower intends to renovate and convert the building to high-end luxury residential condominiums, with a swimming pool, jacuzzi, cabana, sauna and steam room on the roof.  The first floor is currently vacant, with plans to rent to an art gallery. The other five floors are currently leased as commercial space. Most of the tenants have signed termination agreements, but BRT included $500,000 of the loan for buy-out.  

Partially vacant, partially leased. A condominium conversion. Plans to make it the most luxurious residential building in New York City at a time when the market may be cooling or, at very least, residences are taking longer to sell.  

It’s a scenario made for the flexibility, speed, vision and ability to quickly analyze and effect complex deals — the hallmarks of an experienced short-term lender. And, as 2007 plays out on the Northeast real estate landscape, rapid lending responses for those in unusual circumstances based on market decline, as well as those owners seeking to take advantage of exceptional acquisition opportunities, will be fueling demand for short-term lending services.

— Jeffrey Gould is president and CEO of BRT Realty Trust, a Great Neck, New York-based public mortgage REIT.  

Knowledgeable Capital Brings Quick Closure to Reuse Sites

Reliable, swift  capital from knowledgeable real estate capital providers creates opportunities to quickly acquire, develop, and redevelop re-use sites.  
When it comes to reuse sites, most purchasers will attempt to tie up or control the property — but not close — until all of the risks associated with the property are fully understood and priced into the development.

Often times, the preliminary costs and due diligence to understand the site issues are significant, which is why developers typically desire to extend property closing dates until all remediation and entitlement issues have been finalized. Indeed, extended closing dates gives buyers time to raise the necessary capital to close on the reuse opportunity.

Therein lies the problem. All of these extra pre-closing steps are in direct opposition to sellers’ desire for a quick, date-certain closing.

But now developers and investors have realized the benefits of having readily available capital to quickly close on attractively-priced reuse land before all of the unique challenges that accompany such projects have been fully resolved.

Their secret weapon: real estate capital providers, such as Arsenal Real Estate Funds, who provide joint venture equity to real estate operators and developers to fill the capital void for these types of reuse acquisitions. They work side by side with developers before entitlements and/or site clean-ups are completed.

These capital providers invest in the early stages of land reuse projects, and provide knowledgeable capital that can react quickly to tight time frames, evolving reuse plans, and entitlement, approval, environmental and other development issues.

Capital providers understand the significant profit potential created through the acquisition, entitlement and remediation of reuse properties. These firms have established focused investment funds to satisfy unmet capital demand for high-margin reuse opportunities with timing issues or deal complexities.

The Northeast: Geographic Goldmine

The Northeast is an epicenter for the reuse of excess real estate sites and facilities because of its long history as a corporate and manufacturing center. Couple that with the lack of vacant developable infill land and it’s easy to see why developers and investors are discovering the benefits of converting an existing, often outdated, property use to a higher value use.
For instance, the old factories and industrial buildings that dot the Northeast landscape are usually located in population-dense areas near rivers, transportation and employment generators. While these characteristics made for a solid commercial or factory location in the past, they also make for attractive reuse sites today because of their favorable demographics and built-out neighborhoods that provide barriers to new development.

At the same time, many Northeast reuse sites are categorized as brownfields because of their prior commercial or industrial use. The uncertainty and perceived risks surrounding brownfields’ environmental status means knowledgeable buyers can acquire these sites at low cost.
To be sure, brownfield buyers now have a variety of risk management tools to mitigate risks associated with clean-up and redevelopment.

The Brownfields Revitalization and Environmental Restoration Act of 2001, for example, has further encouraged clean-up and redevelopment of contaminated sites by providing release of certain owner liability if a site clean-up is completed according to an approved plan.
Likewise, many Northeast reuse sites qualify for federal or state tax credits or other relief that create additional redevelopment advantages. Often times, communities are receptive to favorable site zoning, development approvals, higher project densities and expedited time frames for land development approvals because it gives affected communities a more desirable alternative use.

By acquiring challenged sites at a cost advantage and then successfully executing a plan to address the site’s complexities, significant capital gain potential exists for such sites once they are fully re-mediated, rezoned, or repositioned.

Arsenal has had great success with such ventures. We recently worked with a leading Northeast developer to acquire about 100 acres of waterfront land just outside of Newport, Rhode Island. The site, formerly a paper company dock, was currently used for construction storage and disposal of dredge materials.

Arsenal provided predevelopment capital to rezone the site for resort residential use while under contract, then acquire the property close to the time of final rezoning approval, remediate the existing environmental issues and commence development of the residential land plan.

Once the land is entitled and environmentally remediated, it will increase in value substantially because the site was acquired for an attractive land price based on its current use. Arsenal provided the bulk of the predevelopment dollars to fund the developer’s efforts to obtain all governmental approvals, clean up the site and complete the land development plan.
Knowledgeable Capital is Key

Indeed, the Northeast has a wealth of opportunities for developers and investors to acquire properties and sites with brownfield, entitlement or other reuse challenges at an attractive cost basis.

Excess profits are achievable to those that can move quickly to understand the reuse potential and have the expertise to execute the plan. Developers must align themselves with legal, environmental, political, entitlement and construction experts to help understand and reduce the risk of the reuse land development process, and create a plan to maximize the value of the reuse opportunity.

Adding knowledgeable capital providers into the mix provides an added advantage to the project. Capital is then available at an early stage when the developer needs it to move swiftly to tie-up suitable reuse parcels. By having knowledgeable capital partners — who will make it to the closing table — developers can take advantage of the discounted price for a quick close or a capital partner’s willingness to provide a significant portion of the capital to advance deposit money, perform comprehensive due diligence and development analysis on sites under contract for purchase, and pay for a portion of the work associated with the development planning and design phase.

The result: a quick close in exchange for a purchase price discount where site complexities with entitlement or remediation allow the property to be acquired for a fraction of the potential market value.

John Maurer is a partner at Arsenal Real Estate Funds in Morristown, N.J.

Specialty Lending Makes Sense in 2007

In recent years, specialty lenders have become more prominent in the real estate lending arena. They seem to have filled a niche or partnered with a traditional lending source to facilitate additional funding for borrowers. Many of these lenders can be private equity sources, hedge funds, pension funds, non-bank lenders and individuals. The focus has been in bridge and construction financing in addition to other short-term loan programs. Their success is a direct result of the changes in the real estate market and the entrepreneurial nature of the industry. Their ability to adapt to market demand has fueled their success. Market trends indicate an increase in asset-based loans and a reduction in traditional bank financing mainly because typical banking sources may not be able to provide the type of loans required by these entrepreneurial borrowers.

One of the major benefits of using this type of lender is not only the speed of execution, but the flexibility of the lender. It is not unusual for a loan to close in less than half the time usually required by traditional lenders. Timing becomes a critical factor when selecting a lender since the need for new funding is almost always time sensitive. This becomes evident when a borrower may have been essentially left at the altar by another lender that has turned a loan down at the last minute after a long underwriting period, and the borrower now only has a limited time to close.

Specialty lenders are not typically subject to the regulatory constraints of institutional lenders. When they are providing senior debt, mezzanine or gap equity financing the flexibility in their funding alternatives becomes very apparent. The loan structures vary and funding can be secured in a number of ways to accommodate the needs of the borrower and the project. Underwriting of the loan tends to focus on the business plan, collateral value and experience of the borrower. Credit worthiness and cash flow are considered, but they are not the driving force behind the underwriting process.

Many borrowers require a hybrid of lending solutions at different stages of their loan or project. Typical lending sources may not have the resources or desire to service these complex and multi-stage loan transactions. Many development deals that require a land acquisition loan are usually combined with some monies for pre-development costs followed by a construction loan. This type of loan can prove to be very tedious due to multiple loan advances. A real estate construction loan can also change frequently, and institutional sources are somewhat inflexible to these types of fluctuations from the original budget.

There are numerous other advantages that specialty lenders provide to the real estate lending arena. Banks often refer loans that have a short fuse or do not fit their lending guidelines to non-traditional lenders. In many cases a borrower may have exceeded the loan limit of their bank or the project type is out of favor.  Referrals in these situations benefit the bank as well as its customers.

Specialty lenders are a good fit for banks since they are transaction oriented and not relationship driven. Banks can refer projects to non-traditional lenders, while still maintaining their relationships. Another bank would only consider the loan if the account relationship follows. There is also an opportunity for institutional sources to provide permanent funding for projects that are financed on an interim basis by specialty lenders. 

Specialty lenders and traditional lenders will work together on certain transactions in order to meet all of the funding needs of the borrower. When evaluating a project it is possible that a specialty lender may eliminate the need for additional equity by providing a higher leverage debt alternative to the borrower. The benefit of structuring a deal this way allows the borrower to retain complete ownership of the project, which will provide higher return to the project sponsors. For example, the bank may provide the senior loan equaling 75 percent of the total costs of the project, where a specialty lender could improve the leverage beyond that point. For these reasons, specialty lenders and traditional sources benefit by working together to meet the needs of each project.

Because of the diverse and entrepreneurial nature of our society, the loan types and structures are constantly changing and evolving making it difficult to standardize such loan programs. The structuring of these multi-faceted, highly complicated loan transactions with multiple moving parts requires a higher level of education and a more complete understanding of asset based lending, structured financed and real estate finance. These transactions have gradually become more sophisticated as borrowers are realizing that non-traditional or specialty lenders are capable of meeting more of their financing needs.

Paul P. Braungart is the founder and president of Regional Capital Group and Ashley M. Miller is a senior associate at the firm. Regional Capital Group is a direct commercial real estate lender based in Marlton, New Jersey.

Lock Me Up

Interest rates continue to be volatile as we move into 2007, and locking in a decent rate on a fixed rate commercial mortgage can be a nerve-racking experience. When looking for a fixed rate commercial loan, knowing where to go and how to lock that rate in are two of the key considerations. 

Finding the right lender for the best deal often depends on the criteria of your loan. Factors such as loan-to-value, the length of term, the amortization schedule, prepayment penalties and tolerance for recourse versus non-recourse can all affect the kind of rate you can get for your loan. Therefore, one of the first steps is to determine a definitive list of priorities for your loan. An active mortgage professional can often be invaluable in your search for the right lender. They will be able to determine which lender would be able to entertain your requirements.

During the last decade, there has been a substantial increase in the number of lenders, loan products and financial instruments. Therefore, borrowers face new challenges and opportunities when they strike out to finance or refinance a commercial property. One of the biggest challenges is the process of locking in an interest rate. Understanding how to lock in your desired interest rate early on in the process is an important variable among the different types of lending sources available. Most fixed rate loans today are provided by commercial banks, life insurance companies, conduit lenders and agencies such as Freddie Mac. Each different lending source will have a specific process for locking in the interest rate, and a borrower should insist that those details are spelled out in the early stages of obtaining a quote or an application.

It is common for lenders to require borrowers to put down deposits in order to lock in a rate. The amount of the deposit is generally large, often 3 percent of the loan amount and is usually refunded to the borrower upon the successful closing of the loan. Securing such a deposit is designed to discourage borrowers from walking away if rates fall after rate lock and before closing. Conduit lenders offer early rate lock options if the borrower is willing to post a deposit and execute a hedge agreement. However, it is important to be aware that a hedge agreement often includes a margin call provision whereby the borrower is obligated to post additional deposit monies if interest rates fall by 0.125 percent or so during the closing process. Receiving a margin call can be unpleasant if you are not expecting it.

In a rising interest rate environment, and if the lenders’ underwriting for the loan tends to be tight, not locking the interest rate can leave you exposed. For example not locking in an interest rate can leave the door open to a reduction in the loan amount or other adjustments to loan terms at a later date. Conversely, once a rate is locked, a borrower is no longer in a position to benefit from falling rates and/or increasing the loan amount or improving various loan terms. Financial instruments offered by lenders or intermediaries to provide protection in a changing rate environment include interest rate cap, interest rate swap, interest rate floor and interest rate collar. Although the decision on when to lock rates is not always clear, borrowers should always understand what it takes to get their rate locked up.

Ron Roth is a director at CBRE | Melody’s Stamford, Connecticut, office.


©2007 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.