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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2009

The $64,000 Multimillion-Dollar Question(s)

Before committing to help a client find financing, ask these four questions

The $64,000 Multimillion-Dollar Question(s)

When prospective clients approach you with a project for which they need financing, what do you do? Mortgage brokers who review deals comprehensively before committing to them may find more success than others. This is because these brokers often can better determine whether these clients and their deals are worth the time and effort involved in finding financing. 
Here are four questions to ask your clients upfront.

1. Stabilized, value-added or opportunistic?

Your first question when a prospective client asks you to help find financing should address the property's status. Is it:

  • Stabilized;
  • Value-added -- i.e., a project to be renovated slightly with tenants remaining in occupancy; or
  • Opportunistic -- i.e., a property requiring major renovation with tenants to be vacated or a property to be developed?

Stabilized properties perform well within their market segment and capture their fair share of the available demand. This means that the properties are fully rented at market rates and have no more than standard market vacancy.

Value-added properties are fully rented but at below-market rental rates. Typically, this indicates a management weakness or a building needing an upgrade to compete in the market effectively. 

Any improvements to these properties can and should be done with little reduction in the existing cash flow. The anticipated value increase should be 10 percent to 20 percent. The investment should generate, depending on the leverage, a 15-percent to 25-percent internal rate of return (IRR) from annual cash flow and a liquidity event such as a sale or refinance. Value creation typically is generated through strengthened management and cosmetic improvements.

Opportunistic properties represent new developments or existing properties that need major renovation that will cause a disruption of the cash flow. When the property is improved, its value should increase by more than 20 percent. Any investment in these properties will earn more than 20-percent IRR from cash flow and a liquidity event.

2. Debt or equity?

Next, you should determine whether clients are seeking debt, equity or both. 

If they are looking for debt only, confirm that they have enough equity to satisfy a lender's requirements. Make sure the equity is in place by signed agreement and that the debt assumption by the investor, if there is one, is realistic. The market is constantly in flux, and you must have a sense of what the present debt market is for the property type.

For example, about 18 months ago, you could find conventional financing for existing stabilized or value-added apartments with an 80-percent loan-to-value (LTV); for retail, office and industrial properties with a 75-percent to 80-percent LTV; and for hotels with a 70-percent to 75-percent LTV. Most of this financing -- done by Wall Street conduit lenders, insurance companies and many banks -- was nonrecourse.

Today -- except for the apartment sector, for which Fannie Mae and Freddie Mac offer financing at 75-percent to 80-percent LTVs and for which the U.S. Department of Housing and Urban Development (HUD) allows 85-percent LTVs -- available financing is recourse and underwritten at far lower LTVs. Retail, office and industrial properties typically require a 60-percent to 70-percent LTV and hotels are generally at 50-percent LTV. Because of the recourse requirement, you must carefully evaluate your clients' financials and make sure they are financeable developers.

Developers are not financeable if their liquidity is less than 5 percent to 10 percent of the project cost and if their net worth is less than 50 percent of the project cost. Carefully evaluate your clients' financials. Too often, net-worth estimates are overly optimistic, given market realities.

When it comes to opportunistic, new-development deals, clients should understand that there is little equity available for anything other than investments into distressed transactions. There appears to be limited equity for value-added transactions, however. This is primarily because existing cash flow and stronger yields relative to those achieved by stabilized assets mitigate investor risk.

3. What's the LTC?

If your clients need financing for a major renovation or a new development, let them know that the old rules of thumb for loan-to-cost (LTC) ratios -- e.g., conventional apartment projects to a 75-percent LTC; retail, office and industrial projects to 70-percent to 75-percent LTC; and hotels at 65-percent to 75-percent LTC -- will most likely be irrelevant.

HUD may be willing to finance apartments and assisted-living and skilled-nursing projects to a 90-percent LTC today, but conventional financing is limited. That said, there are some indications that a small-but-growing number of regional lenders will finance multifamily projects to as much as 70-percent LTC. Financing for retail, office and industrial projects, however, remains limited. If available, it is generally at 60-percent to 70-percent LTC for well-positioned developments that have significant preleasing in hand.

Hotel financing, on the other hand, is virtually nonexistent because of market constraints and overall weaknesses in sector fundamentals. Strong hospitality developers are getting deals done primarily on the strength of their existing institutional relationships. But even these preferred clients are seeing LTC ratios of as little as 40 percent to 50 percent.

4. What's the plan?

Ultimately, your clients' business plan will drive your financing strategy. Unless your clients are planning to sell the property at stabilization, institutional lenders are unlikely to finance the development. If you have access to private money that can do a longer hold, then proceed.

You must evaluate clients' cash-flow projections and project-cost assumptions carefully. Determine what their pro-forma-stabilized income is as a percentage of the overall project cost. 

In today's market, apartment pro formas typically must show no less than a 9-percent return on cost to entice an institutional investor; retail, office and industrial projects must show at least 9.5 percent. Retail will face closer scrutiny because of perceived credit-risk issues involving major tenants. Carefully evaluate the rent roll to determine if any tenants are in jeopardy of bankruptcy or default.

Hotels and assisted-living and independent-living projects should show at least 12-percent returns on cost. These are predicated on allowing the developers to sell or refinance the project and achieve a 20-percent-or-greater profit on the sale of the asset at stabilization. Generally, a 20-percent margin with a two- to three-year exit will generate the required IRRs most investors seek.

Lenders typically will require greater margins for projects that need longer periods to stabilize -- e.g., hotels and assisted-living and independent-living facilities -- and where the perceived risk is greater -- e.g., land, single-family, condominiums and most other opportunistic investments.

If a project doesn't show these kinds of figures, should you pass? Probably, unless you can help drive down project costs or unless the income projection is too conservative. Many developers can be too optimistic, but you may find some who are overly conservative and must be more realistic with their pro formas.

There is a hidden margin value within most projects' cost estimates. You could help clients reduce project costs and increase overall yields, thus allowing for appropriate returns even in today's challenged markets.


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