We all know that the capital markets are constrained due to increased lender scrutiny. So, how can retail real estate deals be financed in the current lending environment?
The real estate landscape for retail property has changed dramatically over the last year. Properties with low occupancies or that are vacant are not valued at their original pro formas, and buyers in the marketplace are not willing to pay for this high-risk space. Essentially, it is difficult to get value out of deals.
When the market was on fire, investors had access to capital and were greatly profiting from almost every deal they sold. Now, many investors do not have access to capital and cannot obtain loan extensions on properties, subsequently forcing them to change their investment goals. The goal now is to mitigate losses and maintain as much profit as possible with retail assets.
However, don't throw your hands in the air and give up just yet. There are ways to salvage deals today, but it takes creative structuring. Although most people think completing a deal is all-or-nothing and black-or-white, there is also a gray area.
We have identified three new ways to creatively structure transactions with financing today that benefit the seller, existing lender and buyer. These special strategies are the break-up sale approach, the synthetic interest-only approach and the low loan-to-value (LTV) seller mezzanine financing.
The break-up sale approach: One of the major problems occurring today is that many developers borrowed from banks for construction loans over the last two years, and those loans are now coming due. These developers, however, do not have the financial statements to obtain a new loan or a loan extension due to tighter lending requirements. So, other than walking away, what can the developers do?
For those struggling with tenancy issues at their properties and facing construction loans coming due, the break-up sale approach might be a viable alternative to obtaining new financing, and it also minimizes the construction lender's exposure.
Specifically, breaking up a property and grouping together the parcels that are 100% leased, while leaving out the vacant parcels, allows for an immediate sale or increases the likelihood of securing more permanent-type financing for the occupied portion of the property.
For example, a developer of a new grocery-anchored center in California recently tried this approach. The developer's project is well located and has had successful leasing activity with credit tenants for the pad spaces, but with the current market, the leasing activity on the shop portion of the space is slow.
The original preference was to sell the property as a whole, but with the construction loan coming due, portions of the center vacant and other sections not yet built, the lender was unwilling to extend the loan. Because the project had already been parcelized, the developer and its partners broke up the property and put the leased pads together.
With only the occupied pads underwritten and that portion presented as 100% leased, a new lender will see a safe and secure collateral base to finance. This arrangement also presents an opportunity for a buyer to purchase a fully leased retail investment with credit tenants.
Using the break-up sale approach also benefits the existing construction lender, which greatly reduces its exposure and amount of the loan and then only carries a very small portion. With the above example, the lender went from an estimated 60% LTV on the total project to 25% LTV on the few pieces that were left.
Even though the construction lender still carries the vacant portion, as long as there is confidence that the space will be leased within a certain period of time, the strategy will likely prove beneficial in two ways.
First, the break-up sale approach greatly reduces the amount of the loan – from $20 million to $6 million in this example, which is a much more manageable amount. Second, the $6 million loan might be on property worth $12 to $14 million once leased.
The lender has ultimately improved its position in today's marketplace. If this strategy were not to be implemented, that loan could be classified or marked to market, which – on an overall loan basis – is a 20% vacant property. These factors would have a major impact on how regulators view that loan.
This strategy benefits the developer, too. It does not need to bring in another equity partner, and while the remaining portion of the project will require some leasing up, instead of having a $20 million outstanding loan, the developer has only a $6 million burden.
In addition, because the loan amount has been reduced, the developer can tap into alternative lenders, such as private lenders, to refinance.
There are lending outlets that will take the remaining pieces on the non-leased portion of the center, underwrite at 50% LTV and make the loan at a higher interest rate. The developer can clear out its account with the existing lender, which is most likely regulated, avoid a potential default and then deal with an unregulated lending source instead.
Another example of a recent break-up sale approach involves a retail project with a vacant inline portion and little tenant activity. In this case, the loan is coming due, but the bank that originally financed the property is now experiencing capital issues and cannot extend the developer's loan.
The developer was advised to parcelize the property, sell off the pads and take the proceeds to pay down the existing construction loan. The developer can now get the original loan to a manageable amount, decide to sell that last parcel to a wholesale buyer and then exit or refinance a much smaller amount by going to a different type of lender, such as a private lender.
If this project were offered for sale in its entirety, the potential buyers would be other developers seeking a much lower price in order to reach their desired returns, especially if they have to wait out the market for leasing.
However, by selling off the pads to more passive buyers, taking in that money and evaluating for how much the inline space would sell, the developer finds that the blended price is much better – with a potential 5.5 or 6 cap rate on the pads versus a possible 9 cap rate on the entire project. Plus, the developer can bring a $15 million loan down to $6 million, and even if the collateral left over is a little dicey, once again, the developer can most likely borrow that amount based on its financial statement.
Synthetic interest-only: In trying to provide more interest-only financing to buyers, in some cases, we are having sellers participate by paying the amortized portion of the loan.
This amount is, in effect, 4.5% of the value of the property, at a 65% loan base. In the case of a $1 million property, the seller might put up $45,000, which, on a five-year term, equates to the principal reduction, based on a normal 30-year amortization.
At the sale, that money is set aside in an account to cover the amortized portion every month. The money in the account can be in the form of an interest-free or low-interest loan, likely unsecured by the property. This strategy helps the buyer feel comfortable that the loan is more like an interest-only loan and increases the cash-on-cash return.Â
At the end of the five-year term to the lender, the loan payoff is still based on an amortized loan and can be paid off by a refinance or sale of the property, including reimbursement of the original seller's holdback.
During this negotiation process, the lender does not need to be involved, as it is underwriting the property for an amortized payment and will make the loan based on those criteria, while the seller offers an interest-only payment to the buyer. The buyer is ultimately responsible to the lender no matter what, but it has an account to draw down principal every month that is set up by the old seller.
This strategy can also be useful when a lender asks for a shorter amortized loan term. For instance, the lender might ask for a 25-year amortization instead of a 30-year amortization.
This shift greatly affects the income stream of the property and could scare away a potential buyer. In this situation, we can mitigate that effect by having the seller offer the full portion of the amortized payment or partial and hold that money in an escrow account.Â
At the end of the term, the portion that was held in the escrow account is basically in the form of an unsecured loan that does not affect the property. This is not a trust deed, but a loan to the buyer, and when the property is refinanced, the buyer will pay off the old seller's portion.
In today's market, we are trying to attract the buyer and, at the same time, work within the parameters of the current lending environment. This strategy offers better cash-on-cash return and might get the buyer over the hump to purchase the property. While the seller does not get interest on the money, it is able to dispose of the property and be reimbursed at the end.
There is, of course, some degree of risk involved with this approach, because the money is unsecured. However, it is a creative way of getting a deal done.
Low-LTV seller mezzanine financing: Because we are primarily working with banks today, this strategy can be used to help sellers dispose of properties on a case-by-case basis. In the case of a sale, the seller can provide secondary financing on the property, giving the first lender a much lower LTV. This technique helps the lender feel more at ease about the collateral it has.
This strategy is particularly useful when there are limited lenders in the marketplace. Lenders who otherwise may be reluctant to loan in today's environment are attracted to deals that provide absolute security in the collateral. Therefore, a lender might be sourced at 50% LTV, with a seller carry-back taking the financing to 65% or 70%.
Brokers will continue to be faced with financing challenges where the developer is stuck, the lender is stuck and the buyer is not willing to purchase vacant portions of the property – basically resulting in market paralysis.
Instead of allowing the lender to take a big hit and seeing the developer walking away, we must get creative with deal structuring and financing so that all parties benefit and deals get done. The order-taking, commodity real estate days are over. It is the responsibility of intermediaries to solve issues for clients and keep the market moving.
Richard Walter is president of Faris Lee Investments, a retail-specialized investment sales team based in Irvine, Calif.Â He can be reached at (949) 221-1800.