I discussed in a BUILDER article on Tuesday how more re-purposing of obsolete suburban office and retail properties is needed but is politically challenging, often due to issues with reduction of municipal tax revenues that occur when a project goes from commercial to residential.
A long-time client who has been successful in the re-purposing or land coverage space read the article and replied with an astute observation that I want to address today:
“Great article, but I have to ask … what lenders will play ball on such re-purposing ideas? Or said differently, what lenders are allowed to play ball? Innovative RE ideas are impossible to get funded right now through primary channels. Secondary channels get prohibitively expensive or are just as scared as the big banks.”
This comment is 100% correct. Assuming that you can negotiate the political pitfalls that often come with re-purposing to residential, it is still quite difficult to finance such a project from a debt perspective, meaning that returns often have to work on an equity-only basis. It’s one thing to find such opportunities in a distressed market but completely another when things are stable. Today I want to take a look at why this is so and what can be done to help find more attractive debt.
First off, there are broadly two types of lenders that provide bridge loans against assets that aren’t stabilized:
Credit or cash flow – lends against a project based on the credit of a borrower and/or tenant. Requires stabilized net operating income or NOI of a certain level to cover debt service on a certain multiple. This can be either recourse or non-recourse debt. Credit or cash flow lenders are typically relatively inexpensive.
Basis – lends against a project based on the value of the underlying collateral alone with less regard for cash flow coverage. Basis lenders are typically more expensive.
There is a place for both of these lenders in the market. For example, basis lenders can often close far faster than credit lenders, have more underwriting flexibility and are easier to qualify for. However, that flexibility and ease of use often means that they are making loans on projects that are perceived to be higher risk and they get compensated accordingly. The higher interest rate can push into the low double digits which is often an issue of contention for equity partners who charge roughly the same or less for their preferred return. As such, most borrowers prefer to go with a credit/cash flow lender if able. So, what makes a project attractive to a credit / cash flow lender? Let’s look at two hypothetical examples:
Borrower 1 is purchasing a 50% leased office building with substantial deferred maintenance. Borrower 1’s business plan is to re-position the building, lease it up at today’s market rents and sell as a fully leased asset in 3 years.
Borrower 2 is purchasing the same 50% leased office building. However, Borrower 2’s business plan is to re-entitle the site for a multi-family development. The entitlement process is projected to take 24 months, during which the underlying lease expires. Borrower 2 does not plan on leasing the vacant space or performing deferred maintenance during that time period.
Borrower 1’s scenario is a “down the middle” loan for a credit / cash flow lender. Borrower 1’s business plan is to improve cash flow through leasing and re-positioning, which puts the lender in a stronger position from both a cash flow and valuation standpoint then they are in initially. The loan for this business plan would likely be non-recourse with a coupon somewhere in the 5% – 7.5% range depending on the leverage with a 1 point origination fee.
Borrower 2’s scenario would not be attractive for a credit / cash flow lender since the success of the business plan is based upon re-entitling to a higher and better use while cash flow dries up. If the re-entitlement were not successful, the property would either have to be entirely re-leased which would require a capital call since such loans typically do not have reserves or sold as a vacant building. Either of these scenarios make such a business plan unattractive to credit / cash flow lenders. As a result, if debt is needed for this business plan, it would likely come from a basis lender and would carry a coupon in the 9%-12% range depending on leverage with a 2% origination fee – substantially more expensive than the debt on the first scenario and much more likely to give an equity partner a serious case of heartburn.
So, what is a borrower to do if they want to finance a land coverage project with lower cost non-recourse debt? My best answer is a hybrid business plan. In other words, develop a business plan to re-lease the building while going through the entitlement process at the same time. A loan to finance such a plan will typically hold back TI’s and leasing commissions to allow for re-tenanting while equity would be used to process the entitlements. Does this drive the cost of the project up and tend to drag project duration out? Absolutely. However, the ability to obtain cheaper debt (often at a substantially higher advance rate) should help to offset the higher basis and it gives the borrower optionality when it comes time to sell. This hybrid plan also has the advantage of a higher degree of downside protection. If the entitlement effort fails, you have a fully leased asset to sell or hold rather than a vacant building to sell or re-tenant.
Assuming that they can get a credit / cash flow lender to put a loan on a project with an entitlement business plan is one of the most comment client mistakes that we see. Even with the hybrid business plan, the key is still to buy at the right price. An asset that trades at an above-market value due to re-entitlement potential is going to be difficult, especially in a mature and stable market. However, if an asset is priced at an attractive level for its current use (after TI/LC and deferred maintenance investments are made), this is a business plan that can make sense for a re-purposing project.