The financial services industry, specifically the real estate capital markets, faces unprecedented challenges that are reshaping the industry in fundamental ways.
As these dramatic changes are implemented, the commercial real estate debt market is struggling to meet demand. Would-be borrowers encounter many obstacles, including:
- The collapse of the distribution channel for securitized debt
- Significant restrictions on doing any new transactions by traditional bank portfolio lenders because of capital concerns
- The tightening of underwriting standards on any new loan requests
- The insistence on short-term, floating-rate debt, generally with some recourse
These changes have pushed some tenant-in-common (TIC) sponsors to the sidelines, and transactions that would have happened 12 months ago are not being completed today. However, some TIC sponsors are finding ways to cope and are staying in business. How are they surviving? Here are a few simple rules and observations.
Things Have Changed, Permanently
Some TIC sponsors are waiting for market conditions to improve, which of course everyone hopes for and expects. However, improving and going back to the debt market conditions of 2005 – 2006 are two different things. The commercial mortgage-backed securities (CMBS) market will never again return to its prominence during the last years of the real estate boom — not just as the lender of first resort but as the dominant lender in the commercial real estate capital markets. Waiting for the CMBS market to come back is not a realistic plan. Anyone charged with finding debt for TIC sponsors must now start developing strategies and relationships with portfolio lenders such as regional banks and life insurance companies, not just for the near term, but as a permanent part of the debt-raising strategy.
Do Not Take Anything for Granted
Lenders are subject to enormous pressures from many directions at the moment, many of which have no relation to the merits of a particular transaction. These pressures are likely to persist for at least six to 12 more months. This means that some previously aggressive lenders will not even look at a deal now, even if the deal makes perfect sense. Therefore, deals must be shown to a broader range of lenders to have a chance at closing. More problematic is the circumstance in which the lender expresses interest, encourages the TIC sponsor to continue the process, uses up time and money, and ultimately elects not to move forward. Worst of all is when the lender has committed to do the transaction but shortly before closing, reneges on its commitment and cites the material adverse change (MAC) clause.
Hopefully, lenders will soon have a better understanding of their ability to lend in the current credit environment and be able to give potential borrowers a more accurate idea of what they can and cannot do much earlier in the process. However, until conditions stabilize, borrowers must develop back-up plans. What options exist if a lender changes course or reneges? No one wants to waste time, money, and effort on back-up lenders. Similarly, lenders do not want to spend time on deals when they know that they are the back-up option. With the very high stakes in TIC closings, this needs to be handled with finesse. At a minimum, it is important to keep possible back-up lenders (e.g., bridge lenders) or possible adjustments to the capital structure (e.g., using seller financing) in mind.
Stay Simple and Conservative
Underwriting has gotten tighter and appraisals more unpredictable. Make sure that the leverage is low — no more than 60 percent — even with low-end value assumptions. Do not project aggressive rent increases, particularly in retail center deals or multi-tenant offices in soft markets. Question vacancy and re-leasing assumptions. Match energy cost projections to current market conditions. Lenders will require these calculations at some point — make sure that the deal will work with conservative assumptions.
For simplicity, a Delaware Statutory Trust (DST) structure may work best for nontraditional lenders — one borrower is better than 35. For a traditional TIC structure, think about designing the offering with a higher minimum and thus fewer TIC investors. Keep to transactions that make sense from the start, not those with complicated re-positioning or value-add strategies. The fewer reasons a lender can reject the transaction, the better.
Reducing Leverage
Keeping leverage low is important. A strong loan-to-value ratio and great coverage minimize the lender’s risks. This may be easier to manage than one would imagine. Over the last few years, the cost of debt has been significantly cheaper than equity, and sponsors were able to improve equity returns by increasing leverage. Now equity may be less expensive than debt, so lower leverage may actually improve returns. In addition, as the cost of debt increases, cap rates also must increase albeit with some delay. This also will help keep returns at historical levels. Rather than buying at a 6.5 percent cap and using leverage to squeeze out a 7.5 percent return, sponsors may be buying at an 8.5 percent cap and keeping leverage low to achieve the same 7.5 percent return.
Layered Debt and Seller Financing
If traditional senior debt can be found (e.g., long-term, fixed rate), at any leverage ratio, it may be worth locking that debt in and building the rest of the “capital stack” with short-term, floating-rate subordinate debt. This type of debt is expensive, so less is better. It may restrict returns or require reserves for a year or two, but at least the deal can get done, with somewhat less cost and risk than using short-term debt for the entire debt portion.
Think Short-Term and Address Refinancing Risk
If the only acceptable choice available for debt is short-term (i.e., three years or less), then consider two issues. First, ask the questions that should always be asked before encouraging someone else to invest: Would I put a significant portion of my net worth into this investment? Do I really think that the refinancing risk in this transaction context is manageable? Second, assuming the answers to the questions above are “yes,” ask: How does one manage that risk and disclose it properly to minimize potential liability?
The best way to manage the risk is to keep the short-term loan balance at a level that can be refinanced. Having a relatively low loan-to-value ratio with good coverage opens many doors to refinancing. Another key is asset type — multifamily, credit tenant office, and retail will always have more options than hotels or senior living.
The next issue, from both a sponsor’s and a broker-dealer/representative’s perspective, is how to make sure that the investor understands the risk being taken and acknowledges that risk upfront. The private placement memorandum (PPM) needs to have highlighted, clear disclosures on this subject, including very specific risk factors. The PPM should communicate clearly that if the property cannot be refinanced, it will have to be sold or may be taken by the initial lender at foreclosure.
Finally, as we all know, refinancing requires 100 percent approval of the TIC investors, and refinancing may not even be possible in a DST structure. Explore with a TIC tax lawyer the potential for getting advance approval in a traditional TIC offering of 100 percent of the TIC investors within certain parameters as to term, rate, and loan amount. If a DST structure is used, the ability to refinance is complicated by the institutional trustee’s unwillingness to exercise discretion and the inflexibility of Rev. Ruling 2004-86. Fixing those problems will require real creativity.
Think Floating Rate and Address Interest Rate Risk
Again, if the only choice available for debt is floating rate, one must ask the same questions: Would I do this with my own money? If so, how do I manage risk?
Buying caps or collars on floating-rate debt is a relatively short-term risk management device. It does not manage the long-term risk and comes at a cost. The real issue is whether or not a fixed rate can be locked in for two to three years without impacting the return to investors adversely. Again, keeping leverage low and having plenty of coverage helps to manage the downside risk.
Without control over where rates will be, it is important that the disclosures present a clear picture of the range of risk. If projections are provided, they should include a sensitivity analysis showing investor returns over a range of interest rates and amortization schedules. The PPM should have a clear warning that there is at least the potential for substantial negative impact on investor returns.
Recourse or Non-Recourse
It has been suggested that more potential lenders, particularly regional banks, might consider TIC lending if some recourse is available. Unless the number of TIC investors is very limited, they are well organized, and they are “super” accredited investors, both in terms of net worth and sophistication, recourse to TIC investors invites serious problems. Most TIC investors are looking to be passive investors; with the nature of the structure, they could not control the investment even if they wanted. Asking for personal recourse is simply not appropriate.
The other side of the spectrum is recourse to the sponsor or, more typically, the sponsor parent. While this facilitates deal flow, it presents a substantial risk for the sponsor/guarantor even where it “controls” the investment through a master lease or property management agreement. There will always be issues that require TIC consent, and what will happen if that consent is not forthcoming? The potential for conflicts is very high, particularly if the loan goes into default and the lender demands payment from the sponsor/guarantor. This could result in the sponsor buying the loan from the lender and commencing a foreclosure action against the TIC investors. The potential for investor counterclaims in that situation also would be very high, putting the TIC investors and the sponsor in directly adverse circumstances.
Given all of these factors, including recourse in an offering should be the very last resort.
Mortgage Brokers
While the use of mortgage brokers was perhaps not always necessary in 2005 – 2006, it is crucial today, even if the sponsor has employees dedicated to placing debt. Today the environment is one of finding debt, not placing it. Presentations need to be carefully prepared and broadly circulated. While mortgage brokers who are experienced in TIC transactions are few in number, experience in TIC transactions is perhaps not as vital in current circumstances as are breadth of coverage and demonstrated ability to execute. Mortgage brokers will require education about TIC transactions, but that will be good practice for educating the lenders themselves.
Stay Confident and Positive
The most critical factor in the coming months will be to project a confident, positive manner to lenders, representatives, and investors. Real estate has a great history of stable returns to lenders and investors. Lenders need to lend and investors to invest, even in current conditions. Everyone is facing the same obstacles. This is a chance to demonstrate the ability to manage in difficult times, and perhaps even gain market share.
Legal News Alert is part of our ongoing commitment to providing up-to-the minute information about pressing concerns or industry issues affecting our TIC clients and colleagues. If you have any questions about this alert or would like to discuss this topic further, please contact your Foley attorney or the following individuals:
Stephen I. Burr, Author
Boston, Massachusetts
617.342.4038
[email protected]
Craig P. Wood
Los Angeles, California
213.972.4555
[email protected]
Kenneth R. Appleby
Boston, Massachusetts
617.342.4091
[email protected]