As the ripple effects from the subprime mortgage crisis continue to make front-page news, the short- and long-term ramifications for commercial real estate developers are beginning to come into focus. Compared to residential real estate, commercial real estate has been relatively resilient so far, but there has been some spillover into commercial real estate markets.
Early concerns of a large-scale commercial real estate crisis and initial wide-eyed speculation of its consequences have eased and, for the most part, been replaced by a more thoughtful and level-headed approach – a practical consideration of how these issues will manifest themselves in the marketplace.
Perhaps not surprisingly, the most pressing and immediate challenge for many developers is to address the issue of tightening capital markets and a national lending slowdown. In a market space where belt-tightening is the order of the day, banks are getting tighter with credit, and developers are subsequently being forced to put more skin in the game.
With lenders growing increasingly conservative, financing has plunged from as high as 90% loan-to-cost (LTC) not too long ago to closer to 65%-70% LTC percent today. The credit crunch and growing need for equity is forcing developers and equity partners to be more creative with their deals – finding new ways to bridge the gap between what developers have traditionally needed to come up with and what the banks require now.
While on the surface that may seem like a challenge, the results might be surprising to those forecasting doom and gloom.
Experienced commercial developers are already finding new and creative ways to secure financing in the wake of the ongoing credit crunch, and the steady accumulation of real-world experience is helping many developers to not only develop sophisticated new strategies for success in the current environment, but also to establish productive relationships with those committed equity partners best suited to successfully navigate through the current challenges and generate long-term value.
Pursuing a partnership
What are those strategies? What is the nature of these equity partnerships? In these challenging times, which developers are best positioned for success, and what kinds of properties and development options are most likely to not only get the dollars today, but to experience long-term success?
Perhaps most importantly, what kinds of new priorities and structural, operational and philosophical changes can provide developers with the best opportunity to successfully bridge the credit gap?
The net result of what can sometimes seem like relentless media coverage of the subprime struggles is that in some circles, real estate is beginning to seem like a four-letter word. It would be a mistake, however, to fall into the trap of making a simplistic industry-wide assessment.
While real estate sometimes gets painted with a very broad brush, industry observers know that there are still abundant opportunities out there for developers who understand how to take advantage of them. Profit margins might be a bit tighter, capital and financing requirements are steeper, and truly exceptional opportunities are somewhat more scarce, but the fundamentals have not changed.
The key for developers, of course, is to get to the long run – to identify the right deals and to find the right partners to allow time for that quality to emerge. Savvy developers are still very active in the marketplace, pursuing deals and approaching opportunities with a genuine long-term perspective.
For these developers, the uncertainties in the current marketplace have actually created more opportunities. Bridging the credit gap is the critical first step toward successfully capitalizing on those opportunities, and it is a process that requires not only finding the right partner, but also staying informed, being creative and maintaining perspective at all times.
No speculation
For developers with big-picture vision, it makes sense to pursue professional partnerships with an equity partner that shares a similar long-term outlook. The get-in-and-get-out model, always somewhat speculative, is even more uncertain and less attractive today.
In the current environment, institutional money may not necessarily be the most readily available, and traditional capital sources that look to maximize return in the short term and then quickly divest may be reticent to jump into a slowing market.
However, capital providers that look to invest in real estate projects for the long term will likely see this current market not as a challenge, but as an opportunity to get in at an advantageous point in the value-creation cycle.
Identify equity partners that look to invest for longer holding periods, even as long as 15 years or more, and whose stake and interests are closely aligned with the long-term growth of your property.
Furthermore, it is vitally important that developers identify and establish a productive working relationship with partners that do not just claim to be in the market, but that are truly out there and actually doing deals.
Be warned that accurate information is at a premium during challenging times in the market, and any developer that is concerned about potentially getting stung by a lender backing out would do well to do as thorough a job as possible of verifying the bonafides of that lending institution. Due diligence is vital.
Additionally, make sure your lender is capable of making good on the loan it says it can make. Avoid unwelcome surprises by ascertaining all possible details early in the process.
Developers and equity partners alike may have once been able to take assurances for granted, but in the current climate, one of the first things that needs to be asked is: ‘Is the lender solid?’ Do not take vague assurances, and do not be afraid to dig deep into the approval process.
Determine precisely what needs to happen for a deal to get approved, and identify who needs to approve it. You will need to know whether that approval ultimately rests with a local, regional or national authority.
Mezzanine options and more
In challenging times, alternative financing sources, such as mezzanine debt, can become more important than ever. A mezzanine loan can help get that 60% LTC figure up closer to 75% or 80%.
While today's development climate presents slightly higher risk than in boom times, many mezzanine providers believe that the perception pendulum has swung too far and are more aggressively entering the market despite perceptions of risk.
In fact, many of the newer mezzanine lenders are not burdened by the past subprime issues that some of the larger players are having to contend with now. A 40% equity gap is an expensive proposition to developers. Even with conservative first-mortgage lending, however, projects should still get done, provided that the mezzanine money can flow.
Within your general financing strategy, do not be afraid to think outside the box. It may even be possible to get a longer-term option on the land – perhaps getting a period of as long as nine to 12 months to close.
Whereas a few years ago, every quality property had nine or 10 potential buyers, now there are generally one or two. In this environment, the landowners do not hold quite as many cards as they used to, and longer-term options may give developers valuable extra time to close.
One possible alternative option, however, if construction loan terms seem too rough and a longer option is not available, is to possibly look to secure a low-level land loan just to hold the site and hang on for a year in the hopes that things improve.
That does introduce an additional element of risk, and developers faced with such a situation might have to take a hard look at the deal and determine whether it is truly worth pursuing or whether it might not make more sense at that point to simply walk away.
Consider the full range of strategic options available to you. Remember that when it comes to financing, creativity does not stop on the dotted line. There are myriad factors that can potentially affect a project's financing.
Accurate, compelling information is an important asset, so do not neglect the potential impact of marketing and communications. The natural impulse in a tight market is to cut back on spending in these areas, but perceptive developers understand that the exact opposite tactic can often be very effective.
While you cannot put lipstick on a pig, and no amount of marketing or communications leverage can make up for less-than-promising demographics or a poor location, clear, consistent and powerful messaging and communications can work wonders to elevate the public profile of a project and convey the potential appeal to lenders.
Developers and equity partners alike that are ready, willing and able to adopt these alternative strategies will find themselves better positioned to minimize the effects of a tighter marketplace.
Long term
In the final analysis, the best thing that a developer can do is to be patient, stay true to the fundamentals and work with trusted, stable and experienced professional partners. The bottom line is that the same distinctions still exist that distinguish quality projects from some of the more questionable ones. The same sound business practices and values still hold true.
Use a tighter market to draw distinctions between yourself and your competitors, to emphasize the quality, care and precision with which projects are designed, built and operated. Developers and their equity partners should look to highlight not only the experience and expertise they bring to the table, but also their track record of investment and follow-through.
Lenders view commitment and long-term vision in a more favorable light than build-and-bail operators, and financing approval and terms are likely to reflect that perspective.
The current market should prompt both individual players and the marketplace as a whole to take a second and third look at what constitutes good real estate. The ability to distinguish between those speculative projects that might succeed and those that are as close as possible to a sure thing is always a coveted quality, but it becomes even more of an asset during periods of instability or uncertainty.
For example, projects that seem to be reliant on future residential development or plan to incorporate residential components will naturally be viewed with a bit more reticence, and projects and properties with fewer moving parts understandably become more attractive. A known quantity is always an attractive proposition for lenders – but even more so in a leaner times.
Good real estate is still defined by location, but also by the viability of the uses, the strength of the market area and overall economics – both local and national.
David St. Pierre is co-founder and president of Lyndhurst, Ohio-based Legacy Capital Partners. The company's second fund, a $47 million private equity fund, closed December 14, 2007, and will be called on to provide equity capital for retail, mixed-use, for-sale residential and office projects nationwide. St. Pierre can be reached at (216) 381-2303 or dsp@lcp1.com.
