The search for yield in a slowing market has investors shifting their focus to more lucrative value-add and opportunistic projects. And, so far, there appears to be plenty of capital to back those strategies.
Buying stabilized assets at this stage of the market is a bit like buying a bond, notes Joe Franzetti, a senior vice president at Berkadia Commercial Mortgage. “So for buyers that are looking for out-sized returns, they are going to look at value-add situations where there is an opportunity to increase cash flow and increase value,” he says. Projects run the gamut from assets that need a facelift or expansion to a complete redevelopment or adaptive reuse.
Debt funds are often taking the lead on providing capital for these value-add deals. “There is a tremendous amount of debt funds and mortgage REITs who are really focused on value-add situations,” notes Franzetti. He estimates that there are nearly 80 different entities that are willing to lend on this type of product, and many are aggressively trying to find deals that work or fit their specific business model. Multifamily investors have the advantage of being able to access capital through Fannie Mae and Freddie Mac. Both agencies have value-add programs with fixed-rate and floating-rate debt that provide pretty attractive financing, notes Jeff Erxleben, an executive vice president and regional managing director at debt and equity provider NorthMarq in Dallas.
Commercial value-add projects are a slightly different story, because they don’t have Fannie and Freddie as a backstop providing additional liquidity. “You are dealing with a debt market that is, generally, speaking, significantly lower leverage,” says Erxleben. Leverage on commercial value-add projects is typically at 60 to 65 percent, with debt coming from banks and bridge lenders. On multifamily deals, balance sheet lenders will come in and provide between 80 and 90 percent of the financing on a floating LIBOR structure that provides the dollars not only for the acquisition, but also for the renovation of the project, he adds.
Life companies also have stepped up their bridge lending activity this year. Pricing and leverage are a little lower on life company bridge loans, but all in all, it is a pretty healthy market between the agencies and various bridge lenders out there from the debt financing standpoint, says Erxleben.
Borrowers get creative
Some borrowers with complex projects are finding that they have to get creative to not only find the best financing options, but start building needed momentum on a project. Earlier this spring, BTI Partners raised $55 million to help kick off redevelopment of The Grove Resort & Spa in Orlando by utilizing tax-exempt bonds. The developers had acquired the busted hotel-condo development at auction in 2014. It included 106 acres and three partially completed towers.
“We do projects all over Florida and we have good relationships with the money center banks,” says Keith Lavery, CFO of Fort Lauderdale-based BTI Partners. However, the investment group also recognized that this project had some unique challenges and higher front-end risk—namely, the likelihood of negative cash flow to start—that would make it difficult to finance the first phase through conventional sources. The large debt funds were interested. However, the cost of capital would have been higher with financing rates in the double digits, notes Lavery.
The bonds, which involved creating a community development district, helped to fund construction of a water park, public parking garages and other infrastructure associated with the resort. They also offered an attractive alternative with a rate that was about 6 percent. The first phase, including 184 of the 292 condo-hotel units, opened in March 2017. The remaining 108 units in tower one will open at the end of October, and the investment group is in the process of lining up financing for phase two.
Now that the project is seeing good acceleration in the sale of the hotel-condo units—275 sales with 100 closings booked—the investment group expects to utilize financing from banks and debt funds for the completion of the remaining two towers, which will likely start work in mid-2018. “We have really good reception and we are in detailed discussion with a handful of lenders,” says Lavery.
Lenders are more selective
There is good liquidity in the market for deals that have higher risk and return strategies. However, lenders are approaching those deals with caution and being more selective. Lenders prefer markets where property fundamentals are strong and job creation is strong. There is also a big focus on the sponsor’s experience and track record in successfully executing value-add deals.
“Big-box retail is probably the toughest to get your arms and legs around, because there is typically not a great solution for converting those assets,” says Erxleben. There is often a lot of space that is lost in the conversion, and they are more difficult to leverage from a debt perspective, because it is not a preferred asset class for lenders. Capital is more expensive and it is harder to make those deals work, he adds.
Banks and life companies will do value-add, but many are steering away from complex deals and focusing on easier, less risky repositioning that might require only modest cosmetic work. “We’ve seen more of the traditional lenders—the banks and life companies—doing light repositioning and they do it at a lower leverage point,” says Franzetti. Even Fannie and Freddie are sticking to deals where the business plans are easily attainable, he adds.
“It doesn’t matter who the lender is, what they are really focusing on is the borrower’s ability to execute that business plan,” says Franzetti. Lenders are getting very comfortable with the borrower, the business plan and the market fundamentals. “For somebody who is branching out into this for the first time, I think it is very hard for them to get financing unless they bring in a partner who has that kind of experience,” he adds.