Avoid financial pitfalls by using resources and managing risk should uncertainty arise.
The recent failures of Signature, Silicon Valley and First Republic banks have many in the industry evaluating their financing options and examining their risk management strategies. One thing is certain in a sea of uncertainty: Due diligence is key for organizations searching for a lender or partner for projects.
“Traditionally, lenders perform due diligence on their borrowers, but with today’s banking volatility, borrowers need to do their homework, too,” says Jack Laughlin, Investment Manager at Pangea Mortgage Capital. He says to work with more than just banks—explore mortgage brokers and alternative lenders, too. “Borrowers should also understand how the firm is capitalized—deposits, balance sheet, life insurance company, etc.—as this information can help borrowers gauge closing risk.”
Risks
There are numerous potential risks facing the industry, including regulatory issues, inflation and economic uncertainty.
“A recession does not mean there will not be demand for rental housing, but rather that building owners may not be able to achieve top-of-market rents in less desirable locations or buildings,” says Ross Stiteley, Director of Development, Roers Companies. “Diversifying your asset classes can also mitigate risk. Finally, keeping a healthy amount of liquidity and not overexposing yourself to variable-rate debt can also be useful hedging tools.”
Laughlin says there are two factors to consider when evaluating traditional financing risks: Credit and time. “The credit criteria for traditional financiers are often more rigid, so they have less flexibility when issues arise, or markets move. On top of this, traditional financiers take relatively longer to close.” Nontraditional lenders, on the other hand, typically have smaller portfolios, “so economic distress may have a more immediate impact on their business if they’re not well diversified. When working with an alternative financier, borrowers should ask how the company is capitalized and how their portfolio is performing.”
Jon Morgan, Co-Founder and Managing Principal of Interra Realty, says, “One pitfall that borrowers should be aware of when pursuing nontraditional financing is the prevalence of loan-to-own financiers in the marketplace who lend with the intent to acquire properties at a low cost via foreclosure.”
When Problems Occur
It’s important to be flexible and act quickly when financing issues become prevalent. Making changes late into a project can interfere with costs and timelines. Lender stability is only one aspect; there are other factors involved in trying to find a solution.
“A lot of people are seeking rescue capital in the form of new investment into deals that can take priority over existing equity investors, ultimately bridging any gap in what they can get in senior financing. This is helpful for when a refinancing leaves an owner short of proceeds and they need to bring new money into a deal,” says Morgan.
While time and money are ultimately at stake, due diligence is a must. “If a borrower senses that a lender is getting cold feet, however, they may need to ask the tough questions and go back out to market before wasting more money on a failing closing,” says Laughlin.
Outside of financial institution failure, there are other risks such as higher interest rates and materials costs.
“To hedge against higher interest rates, borrowers can purchase rate caps, but they are often cost prohibitive today,” says Laughlin. “Many borrowers are having success asking for price reductions on acquisitions, making their deal more financeable.”
Stiteley says they have witnessed materials costs decline along with the price of labor.
To combat the potential of rising costs, Morgan says developers are buying products early like elevators and windows. “This helps them avoid longer lead times and maintain price certainty in project costs.”
Nontraditional Financing Options
Stepping away from traditional financing options is a solution. Those include debt funds and private capital lenders. These alternative financing options are usually best accessed through a broker, says Laughlin. “Private lenders often specialize in certain transaction types, such as lien priority (senior vs. mezzanine), term (bridge vs. semi-perm) or asset class.”
Debt funds and balance sheet lenders “lend out their investors’ (pension funds, life insurance companies, high-net-worth individuals, etc.) private capital, or sometimes, as the name suggests, finance using their own balance sheet funds.”
Roers Companies has been using participation loans. “This has allowed us to pursue higher leverage loans than what are currently available with more traditional banks. Speaking with larger mortgage broker firms will help you determine if this is a viable financing option for your project,” says Stiteley.
Future
Transaction volume has changed during the past 12 months. They have slowed for many or have stopped altogether. This is in part due to the economic climate with inflation and a recession on the horizon.
Laughlin says they have seen a sharp decrease in multifamily deals. “Interest rates and underwriting standards have increased, yielding a macro decline in property value. Many owners are reluctant to list their assets because they won’t fetch the same price as a year ago. Transactions may tick up in the second half of 2023, but distressed sales will likely lead the charge.”
Morgan says deals are still happening but at a slower pace than a year ago, with the hope for additional opportunities in the second half of the year. “We fully expect that, as the treasuries move to stabilize, there will be more velocity in the marketplace in the second half of the year.”
While Stiteley has not seen a drop in transaction volume, he says transactions are taking longer to close due to the “additional scrutiny during the due diligence process. I don’t see this changing in the second half of 2023.”
The Great Recession
“During the Great Recession, we saw large portions of the lending community just outright sitting on the sidelines. Today, while we’ve seen some lending institutions pull back some and/or take some more conservative stances on underwriting, we are not seeing as many of them putting full holds on lending. During the Great Recession, we also saw a number of development companies go out of business completely, which doesn’t seem to be happening.”
— Ross Stiteley
“The Great Recession was systemic across real estate. This time around, the housing market remains strong even with little to no inventory in the single-family marketplace. Office seems to struggle the most right now, but in the multifamily space, occupancy and rent levels are robust – mostly driven by a lack of affordable housing, compelling those that would alternatively want to buy a single-family house or townhome to remain renters.”
— Jon Morgan
Affordable Housing
“Organizations focused on affordable housing must continue to focus on the things they can control, like a hyper-focus on design in an effort to control construction pricing. Additionally, cast a wide net in regard to soft financing that might be available. Whether through the state, county or municipality, there are a large number of possible gap-filling solutions. We have found that at the right price (or leverage amount), there will be an interested party in providing debt/equity. We’ve seen those prices fall recently, creating financing caps, but with the right combination of soft financing options you should still have a viable financing stack.”
— Ross Stiteley
“Deals that involve an actual affordability component – such as a deed restriction or subsidy program—often fall through during due diligence because the lender team that initially approved the deal didn’t understand the full implication of the affordability component on the physical real estate. Borrowers need to confirm up front that their lender has experience in and has financed their particular type of transaction.”
— Jack Laughlin
Michael Miller is NAA’s Managing Editor.