COVER STORY, FEBRUARY 2005

FUNDS & FUNDAMENTALS
Combine healthy fundamentals with the right financing for a strong commercial real estate investment.
Michael Gottlieb

Gottlieb

With money continuing to flood into the commercial real estate market, any project that looks halfway decent can get funded by someone. The question is: will it be the right loan for the investor?

The easiest loans to obtain right now for California properties are for multifamily, grocery-anchored retail, multi-tenant industrial and Class A office properties with strong credit tenants. So if an investor has one of these properties lined up and has managed to get into the winner’s seat after the bidding war, he or she is likely to be able to get financing in place fairly easily.

However, some closings are seeing a 30-day or less escrow period, indicating that the ability to close quickly can be the difference in getting a property under contract. Turning to a mortgage investment banker will give the borrower the flexibility and creative options to fund much more quickly.

In addition to a quicker close, mortgage investment bankers are able to search the vast universe of lenders and get them to compete for the business. This competition will result in the borrower achieving a lower rate and higher leverage, which sometimes can make the difference in whether or not a deal pencils.

Still, while the structure of the financing can be a key factor on a marginal deal, the true key to the deal — now more than ever — is that the fundamentals have to be in place. At this point in time, when many people perceive we are at the top of the market, buying right is far and away the most important criteria. Presuming that the project does make sense, it is then up to the borrower to work with a mortgage investment banker to ensure that the underlying financing makes the most of the project. If an investor is savvy in his or her financing structure, the deal can create larger returns, build better-leveraged portfolios, and/or provide more generous tax benefits.

There are several options for structuring financing today:

• Interest-Only Loans

Interest-only loans provide maximum cash flow to the investor. By only paying interest, the full payment can be deducted from income to increase after-tax cash flow. When amortization is involved, the portion of principal pay-down is not deductible. On a value-added transaction, when income will be increasing over time, sometimes the lender will go interest only in the first few years, then start amortizing. Most of those involved in value-added transactions typically sell the property off after a couple of years making the interest-only option in the first few years very important.

• High Leverage Loans (up to 85 percent of purchase price or value)

With low interest rates, investors are trying to maximize leverage because debt is relatively inexpensive compared to historical rates. This can benefit the buyer of a stabilized property or a value-added property. The buyers of both can minimize their down payment, which means they don’t necessarily have to bring in outside equity (which costs substantially more than debt).

• Mezzanine

On top of the high-leverage debt, mezzanine lenders will lend in either a second trust deed position or they will take partnership interest as collateral. Mezzanine financing can climb as high as 90 to 95 percent of total cost. Rates have come down dramatically over the last few years and can be as low as 10 percent or as high as 20 percent, depending on the risk level.

• Equity

Equity partners can invest up to 90 to 100 percent of the equity requirement necessary for a transaction. Unlike mezzanine financing, the equity partner takes a substantial percentage of the ownership equity and typically gets a preferred return on the investment. After the preferred return, there are pre-arranged profit participation splits based on internal rates of return during the life of the investment. Most equity partners are shorter term — 3 to 5 years. It is more difficult, but not impossible, to find longer-term equity.

An experienced commercial real estate investment firm can arrange several deals with one of the above features in the financial structuring. One example is a $5.1 million construction loan and mezzanine financing for the development of five high-end homes. A Southern California-based firm was able to arrange 96 percent of the total financing for the project. The prime location of the deal on the central coast of California with ocean views made this residential project attractive to lenders. Although the location makes this property easier to finance, the fact that the firm structured the deal with two key ingredients — mezzanine financing and an interest-only loan — gives the borrower tremendous value. In addition to lowering carry costs to interest only, there is also a fully funded interest reserve, which gives the borrower even more security. Once the houses are developed and sold, the borrower will be able to pay off the loans quickly.

In another example, the same commercial real estate investment firm arranged for a $52 million cash-out refinance at the low rate of 1.25 percent over LIBOR for two well-kept, fully occupied Southern California apartment complexes. The borrower had only limited funds to invest in its real estate properties. Since the loan is interest only for the first 1 to 2 years, the borrower not only pays the lower interest-only payment, but will also be able to reinvest the cash out and leverage it for other lucrative deals.

With the right deal, lenders and borrowers may be satisfied about their investment. But with the right financing, the deal could be a dream come true, monetarily speaking.

Michael Gottlieb is a senior vice president at George Smith Partners.


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