FEATURE ARTICLE, MAY 2007

LIQUIDITY AND INNOVATION BENEFIT BORROWERS
Structured finance can offer investors a world of opportunity when investing in the Northeast.
Ronnie Levine

Today, the world of structured real estate finance presents great opportunities for borrowers. Taking advantage of current market conditions, they can do more than merely secure financing, or refinancing, for a real estate project. They can customize exactly the right kind of financing for their project.

The current state of the real estate capital markets can be summarized in three simplified statements:

• First, lenders have an extraordinary amount of money allocated to place into the real estate sector.   

• Second, lenders have devised new and innovative structures that allow loans to be customized to borrowers’ specific needs.

• And third, when new and more flexible lending mechanisms arise, everyone on Wall Street learns about them very quickly, and puts them into use immediately. 

Taken together, these factors combine to benefit the informed borrower who is seeking to close the best possible economic deal — packaged within the most favorable structure.

The first factor, lenders have a lot to lend, benefits the borrower thanks to the power of competition. The market is awash in capital liquidity. The United States’ real estate remains one of the most favored asset classes for domestic and overseas investors. Because lenders are competing with one another, they are acting aggressively to win business. In addition, the competitive lending environment keeps the cost of capital at an affordable level. Lenders are willing to invest in a wider range of property types than they were just a couple of years ago. Today, lenders are more aggressive in terms of their underwriting structures and in terms of the types of deals they are willing to do. Borrowers are thus able to obtain attractive financing today for an asset that would have been overlooked by the marketplace only a short time ago.

The second factor, the presence of new and more flexible loan structures, also works to the advantage of borrowers. For example, collateralized debt obligations (CDO) have quickly begun to make their presence felt in the marketplace.  Defined as an investment-grade security backed by a pool of bonds, loans and other assets, CDO executions are becoming increasingly popular with lenders, who also sometimes use them in combination with traditional CMBS sources in a hybrid fashion.

Today’s CDO market represents just the tip of the iceberg in anticipation of what is to come within the next 12 or 18 months. Meridian Capital Group confidently foresees lenders rolling out growing numbers of CDO executions, and we expect CDOs to be used in a wider variety of deals such as land loans, vacant buildings and repositioning projects.

Spurred by the competition and propelled by vast liquidity, the lending community is also demonstrating new flexibility when it comes to construction loans associated with ground-up development.

For example, Wall Street lenders have taken a page from the insurance companies’ book in respect to retail construction.  While working at a higher leverage than their insurance counterparts, conduits are now offering long-term, fixed-rate loans that roll into permanent financing. Because the current yield curve is so flat, there is less of a premium for forward take-out financing than there was just a few years ago. To attract this kind of flexibility on ground-up retail, however, it is almost always necessary for some pre-leasing, especially anchor tenants, to be in place. In any case, the borrower reaps benefit in this structure by being able to close the construction and perm components simultaneously with a single transaction and by eliminating interest rate risk on the take out.

Wall Street is also showing increased prepayment flexibility structured into CMBS loans. This flexibility often comes with an increase in cost to the borrower. Many are willing to pay up, however, in order to benefit from longer open periods and sliding scale prepayment structures.

The third factor cited above, the rapid diffusion of innovative structures throughout Wall Street, is a consideration that has been around for a while and is not entirely tied to present trends. But it has been abetted by new corporate reporting rules demanding transparency and stakeholder accountability.

When a new structure hits the street, people hear about it quickly. The learning curve is, in a word, viral. Everyone learns from everyone else. Everybody reads everybody else’s prospectuses. Everyone is trying to sell to the same bond buyers. Rating agencies are continuously analyzing and monitoring trends in deal structure. There are really no secrets anymore. Dealmakers in the finance community are constantly reverse-engineering one another’s deals. There is a vast amount of public information available in this more transparent era. Lenders are simply less able to keep their innovative structures proprietary. In such a milieu, one lender closes an innovative deal, and then that deal format shortly becomes the industry standard. 

With market conditions like these, borrowers would seem to be in an excellent position to invest successfully in commercial real estate. But there is one more important consideration: In a market with so much capital, in a market with so many new and flexible deal structures, and in a market where every innovation is almost instantaneously diffused throughout the entire industry, it is riskier than ever for borrowers to go directly to a lender for financing. It is difficult to navigate the swift currents of this rapidly changing capital marketplace. At a time like this, we believe that it is essential to tap the services of a capital advisor who can guide a borrower through the ever-changing maze of deal structures and lenders, and who, among an abundance of options, can tailor a structure truly suited to a borrower’s specific needs.

In this market environment, my colleagues and I have all seen sophisticated borrowers quickly lose their initial confidence in being able to go to a lender and broker their own deal. They discover that the process is simply too demanding. These borrowers recognize the growing volume and complexity transactions. They understand that it is really a full-time job to monitor emerging trends in the structured finance market. 

The stakes are high and there are abundant opportunities for success. But under today’s conditions, borrowers need to be partnering with advisors and intermediaries who are out there in the trenches every day, who know how to stay in the vanguard of a fast-moving innovation curve, and who can easily spot what is coming up over the next horizon. 

Ronnie Levine is the managing director of Meridian Capital Group.


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