As private real estate investment capital increases, real estate owners must find the right capital stack for their projects. The key is to understand the advantages and opportunities of each level of the capital stack, and determine how they align with the owner’s overall strategy.
Senior Debt And Low Cost Of Funds
For a long-term real estate project, an owner may consider a capital stack that is financed by senior debt. The costs of funds for senior debt are relatively low compared to historical rates, and banks are still hungry for deals. More owners are securing long-term interest rates on senior debt.
Exact price differentials between the term sheets offered by banks could be minimal, so owners must look at other factors, like the terms and conditions and the length of time until maturity. The owner must determine whether the offer is recourse or non-recourse. The term to maturity for commercial real estate is usually five to 10 years, and owners should generally aim for the longest maturity possible. Several banks only offer a floating rate, and some may offer an interest rate hedge through a swap derivative or building it into a fixed rate.
With Jerome Powell as the new chairman of the Federal Reserve, experts are forecasting a gradual increase in the interest rates, which will make real estate financing more costly in the future. The extra cost of an interest rate swap on a long-term financing could benefit an owner if base interest rates start to move up to 4% or more. While not paying for interest rate protection in the form of a swap or hedge worked out for borrowers in the most current cycle, there are strong expectations for a rising rate environment going forward.
Mezzanine Or Subordinated Debt: Filling The Gap
If there is a gap between the senior debt amount and the equity portion, an owner may consider taking out mezzanine or subordinated debt. This type of financing is more expensive than senior debt, but less expensive than equity. The rates tend to fall in the low- to mid-teens, depending on the property, project and cash flows. This type of financing can also bring in one more party in the Intercreditor Agreement and negotiations to see if the transaction needs this type of financing.
Equity
If the equity requirement for a property cannot be raised by the owners, then they must explore additional equity funding sources. When looking for equity, owners must decide if their needs are for a single transaction or multiple transactions. The single transaction usually applies when the owner is occupying the property, while the multiple or program is usually for real estate developers. This differentiation will separate potential investors into different categories. For single transactions, an owner must focus what the particular property means to the owner. For a program, the focus is on the management team and their strategy. Some investors want specific types of real estate or projects, while others are more interested in geographic locations. Some investors are more interested in looking at the numbers and the cash flows. Despite these differences, most investors want details about the exit strategy. They need to know what their options are if the program or one-off goes sideways. The next step is to identify interested investors. Institutional investors have shown increased interest in the CRE market.
Finding The Right Fit
The capital stack for a CRE project depends on various factors and circumstances, such as the specific project level of risk, location and property type. The impacts of tax reform and additional pending interest rate hikes are driving owners and developers to secure project financing ahead of time.
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