How Can Minnesota Real Estate Developers Access Capital While Minimizing Risk? Structured financing

The twin cities of Minneapolis and St. Paul continue to be a very attractive market for multi-family investment due to an average subway vacancy rate of 3.1%, as well as average rental growth in January. 2019 by 5.8%, according to a recent report published by Marquette. Advisors. The Twin Cities currently have nearly 30,000 multi-family units under development that are expected to be delivered between 2020 and 2022.

With all this development activity and an abundance of local and regional banks in the region, the Twin Cities continue to be a very well banked market, especially when it comes to apartment building. Local and regional banks are all very active. In addition, national banks are keen to invest in the healthy and cohesive multifamily market of Twin Cities.

Dan Trebil, NorthMarq

But although capital is relatively abundant and accessible, local, regional and national developers are exploring more effective ways to capitalize on the abundance of development activity. They are also looking for ways to expand their own equity through a variety of financing alternatives. Developers may be sidelined with their current banking relationships, or as projects get bigger and more expensive, desired loan amounts may exceed their banks’ loan limits.

Lenders and developers are aware and sensitive to where we are in the current cycle. While most metrics are still optimistic, multi-family developers are exploring creative ways to mitigate their risk and structure transactions to minimize their individual capital contributions.

Developers are increasingly looking for non-recourse or limited recourse construction loans. FHA / HUD provides high leverage, non-recourse construction financing. However, not all projects qualify for FHA / HUD, and due to the long lead time required, this may not be time-wise. For other loan options, it is important to note that the level of recourse is generally directly proportional to the leverage. As a result, we regularly see developers opting for lower leverage (think 50-65% loan-to-cost (LTC)).

Many developers have grown up accessing capital through friends and family or “country club” equity. As the number of projects undertaken by the developer increases, he may conclude that raising equity from high net worth individuals is often ineffective. The search for institutional alternatives allows developers to carry out more and more important projects in an efficient way, while simultaneously minimizing disbursements and risks thanks to the use of structuring financing.

Alternative financing

Structured finance vehicles are finance programs that bridge the gap in the capital stack between a traditional first mortgage and a developer’s equity. These programs are used more and more as developers become more sophisticated and strive to mitigate their risks.

Here are some examples of these programs:

• Mezzanine financing

• Preferred shares

Debt with participation

• Joint venture capital

Mezzanine debt is added to the first mortgage for higher leverage. Mezzanine debt increases debt from 50 to 55% LTC to 80 to 85% LTC. The current price is around 9 to 12 percent.

Preferred shares slightly higher the capital stack at 85 to 90 percent LTC. The cost of capital is generally low to middle adolescence. The preferred stock provider is usually paid first, up to a specified return before the developer receives the proceeds from cash flow, refinancing, or sale.

Debt with participation is a hybrid debt / equity option whereby the lender finances 90-95% of the cost of the project. Free cash generated by the project through cash flow from operations or a sale is used to pay a predetermined rate on the lender’s funds and then split between the lender and the developer at around 45% / 55%.

Joint venture capital allows the sponsor to complete a project with the least amount of capital available. Institutional joint venture partners will provide up to 90 to 95 percent of the overall capital requirement for a project.

There are a multitude of sources for each of these options. Institutions such as life insurance companies, pension funds and other opportunistic funds simply looking to generate a return may be suitable options. Additionally, there are groups that participate across the spectrum listed above. Some pension funds and union debt funds have programs where they provide almost the entire capital stack, from first mortgage financing to leveraged financing for joint venture partners. It is a “one-stop-shop” whose rate is ultimately based on the mixture of rates at various points along the leverage curve.

Of course, for each of the benefits of these structured options, there are tradeoffs as well. For example, the main objection most developers have to structured finance is a potential loss of control. As a general rule, as you increase the leverage, the institution providing the additional capital tends to increasingly want to take an active role in decision-making regarding the project. This includes everything from major decisions such as a recapitalization or divestiture, to more minor issues such as finishing and marketing.

A recent transaction in Minneapolis began with a comprehensive search for development debt and equity on an apartment project to be built at market rates in the Twin Cities. The promoter had already taken out his first mortgage as part of an existing banking relationship. The developer then hired NorthMarq to provide options for additional third-party leverage. After considering several possibilities, the developer chose to use mezzanine debt because it offered the best combination of price and additional leverage while maintaining control of the developer.

Of course, whatever the scenario, the structured vehicle used should align with the developer’s exit schedule and strategy. The good news is that as capital remains plentiful, we are able to identify a variety of options to meet short-term and long-term capital needs at varying levels of leverage.

– By Dan Trebil, Senior Vice President / General Manager, NorthMarq Minneapolis. This article originally appeared in the March 2020 issue of Heartland Real Estate Business magazine.

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