FEATURE ARTICLE, JUNE 2006

STRUCTURED FINANCE: WHY ITS TIME IS NOW
The many financial challenges involving today’s multi-faceted properties and projects call for a multi-tiered approach.
Gary Mozer

Mozer

While there is universal agreement about structured finance’s growing importance in the real estate market, its formal definition remains up for debate. At its essence, structured finance has two defining characteristics: it encompasses any type of financing that is not a “plain vanilla,” standardized loan type, and it is often used for the acquisition and/or repositioning of an asset.

Structured finance typically features three tranches of financing: senior debt represents the A piece of the loan, followed by two subordinate pieces in the capital structure. This usually includes mezzanine debt and equity.

So why has this multi-tiered approach to financing become such a mainstay in the commercial real estate industry? The following are a few reasons why.

Access to Available Capital

The primary thrust behind structuring acquisitions is access. The commercial real estate market is currently experiencing an unprecedented influx of new and eager investors, bringing high levels of liquidity.

Since there is currently a very low yield on alternative investments, a broad array of investors — including Wall Street, hedge funds, pensions, TICs and individual investors — is setting its sights on the real estate market. The result is a higher reserve of available capital than ever before. Structured finance has given financial intermediaries the ability to tap into this equity by structuring acquisitions with multiple levels of debt from a myriad of sources, providing investors with more flexibility and better options.

Opportunity for Large Promotes

Structured finance has given many investors a chance to acquire a property with considerably less equity, using expertise as a core commodity.

In structured finance, the “promote” is king. For example, if two partners enter a transaction together, one with substantial equity and the other with structuring expertise, the first partner may contribute 95 percent of the equity, while the other may only cover the other 5 percent. Upon completion, the property is split 50/50 between each partner, with the expert being rewarded considerably for his structuring know-how.

The promote represents the additional 45 percent earned for structuring the transaction and provides savvy investors with the opportunity to gain a lucrative share in a property by contributing expertise and very little capital.

The Growing Influence of Mixed-Use Properties

The emergence of the mixed-use property segment is being fueled by two key factors. First, urbanization is rapidly growing in popularity, and, second, the continued ascent of land prices is leading developers to aggressively search for new and creative ways to increase density. This has lead to a wealth of developments that bring together multiple product types, such as office/multifamily or retail/multifamily. Unfortunately, many of these marriages are not a match made in heaven.

For example, many multifamily investors prefer not to invest in retail, and many retail investors are averse to multifamily properties. This requires financial intermediaries to find sources that are comfortable investing in a property that does not fall into the “four basic food groups” of real estate — office, industrial, retail and multifamily. The interconnection between these multiple product types also requires a broad-based financing strategy that caters to the diverse needs of each product type involved in the development.

Challenges in Structured Finance

While any structured finance comes with a variety of built-in challenges, several property types are considerably more difficult to finance. The first category includes operating-oriented properties, such as mini-storage and skilled-nursing facilities. These product types, which were substantially affected by the last real estate bust, tend to be most affected by negative economic trends.

Single-tenant, non-investment-grade properties also present a formidable challenge, due to their higher degree of risk, with many lenders frightened by the prospect of a vacant building and the inability to disperse the risk.

On a broader scale, structured finance’s growing popularity has become its greatest challenge. The commercial real estate market is now packed with competition, which has brought a new sense of urgency to the financing environment. One of the most recognizable results of this high level of competition has been the need to execute a much more proactive strategy when seeking out potential lenders.

For example, transactions that previously required a dialogue with three to four potential lenders may now call for conversations between 20 to 30 different lenders. This is a testament to the growing number of lenders now participating in the market, combined with the intense competition for their business.

Unfortunately, taking such a comprehensive approach requires time, a resource that is becoming less and less available. Deals now must close as fast as possible, with many transactions featuring a remarkably short deadline. Meeting these deadlines has often required financial intermediaries to bypass the best overall deal for the one with the fastest close. Working in this time-sensitive environment often requires creative structuring and the ability to adapt quickly to changing variables.

The Future of Structured Finance

While there has never been a more appropriate time for structured finance than now, many questions remain about the future. A number of analysts believe lower yields and shrinking cap rates will usher in a slowdown for real estate investment. What’s more, the imminent rise in interest rates has made many investors skittish about the sustainability of the market, leading to decreased property values.

However, rising interest rates may actually be a boon to structured finance. Since structured finance is employed to reposition assets, there will be a large demand for financing strategies that are capable of reviving these properties and repairing financial structures that have been “damaged” by rising rates. Furthermore, if the market tightens up, senior lenders are expected to become more conservative in their lending strategies. This will undoubtedly require buyers to seek out additional sources of debt that are subordinate to senior debt, such as mezzanine and bridge financing.

As the future of the commercial real estate industry remains in question, the need for financial intermediaries who are well versed in structuring complex transactions will become even more apparent. Leveraging these capabilities will better ensure a bright future, regardless of the storm clouds on the horizon.

Gary Mozer is chief executive officer and partner at George Smith Partners Inc.

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