Deeper Into The Capital Stack

Posted by msmessenger on Mar 31, 2017 11:00:00 PM

The Advantages Of Non-Recourse Bridge Financing At Certificate Of Occupancy

Construction lenders are not a dime a dozen, and good ones are extremely valuable. The challenge, however, is most simply do not have the capacity or risk tolerance needed to finance multiple deals for the same sponsor simultaneously. This is a problem active developers with multiple projects face, and it can bottleneck your development pipeline. To resolve this issue, developers should be more strategic about their financing strategy. By taking advantage of non-recourse bridge financing that is available at certificate of occupancy (C/O), one can free up the construction lenders’ valuable capacity by reducing their exposure to the developer’s pipeline earlier in the process. At the same time, the developer can reduce contingent liabilities by taking advantage of the non-recourse nature of the bridge financing. This solution alleviates the bottleneck and creates greater efficiencies by utilizing a more programmatic approach to financing development pipelines.

The example below contemplates a typical self-storage development transaction and associated development timeline. One can compare and contrast traditional construction mini-perm financing, which carries the project through lease-up, to the two-step process outlined here, which contemplates a typical short-term construction loan with a bridge financing takeout at certificate of occupancy. Undoubtedly, there are additional costs associated with a two-step process; however, the primary benefit of this strategy is to resolve capacity issues with the primary construction lender(s). Locating and grooming construction lenders is a time consuming and, therefore, expensive process. Introducing a repeatable programmatic two-step strategy will help developers that currently have or anticipate various projects going simultaneously, thereby streamlining the process and creating efficiencies of scale.

Certificate Of Occupancy And Value Creation
To keep the math simple, let’s consider a $10 million development project financed by a traditional construction lender at 60 percent loan to cost (LTC). The recourse aspect in this deal is somewhat irrelevant because the developer is required to provide a completion guarantee regardless; even if the loan package were non-recourse in nature, that contingency would not be removed until the build is completed and the C/O is obtained.

Let’s assume the sample deal below is targeting a minimum development yield of 9.5 percent. The developer plans to sell the asset at a six percent terminal (stabilized) capitalization rate (cap rate) once the project is fully leased. Due in large part to the public REIT-fueled consolidation happening in the self-storage industry, a well-conceived and completed project that receives C/O is immediately more valuable than the cost to build it. REITs are typically not developers; however, they are comfortable undertaking lease-up risk and will target facilities in their core markets where they feel there is demand for product. As a result, the REITs rely on merchant builders to construct modern institutional facilities, which they can acquire at C/O at some discount to projected stabilized value. There are many factors impacting the value a REIT will ultimately assign to a newly completed self-storage facility (which we won’t cover in this paper), but generally this discount ranges between 100 and 250 basis points from the terminal (stabilized) cap rate (the example below uses a 7.75 percent cap rate, which is a 175 basis point discount from the stabilized cap rate). In other words, the project that cost $10 million would theoretically be valued at approximately $12.3 million at C/O, and ultimately worth $15.8 million at stabilization.

This incremental value creation is the key to the two-step process. The bridge lender is comfortable lending because the incremental value created at C/O allows them to reach deeper into the capital stack; with construction risk behind them the bridge lender is willing to lend the lesser of 70 percent of the initial loan to cost (LTC) or 60 percent of the loan to value (LTV) at C/O. In the example below, this creates $1 million of incremental loan proceeds. Although the debt is more expensive, the lender will escrow 115 percent of the estimated interest carry and operating reserve at closing, which is taken from the incremental loan proceeds borrowed.

Advantages Of C/O Bridge Takeout
As previously mentioned, the primary benefit of this financing strategy is to diversify developers financing sources and free up the construction lenders’ valuable capacity, reducing their exposure to the developers’ pipeline earlier in the process.

Secondly, it can buy the project more time. If a project experiences delays in construction and takes more than 12 months to build, as originally contemplated, the new bridge loan will reset the clock at a 36-month term, allowing the full 36 months to lease up. In the traditional construction mini-perm financing, that delay would have compromised the 36-month lease-up tail, likely creating stress on the loan covenant “tests” built in to measure the project’s health. The bridge loan also provides for two, one-year extension options, which can be exercised at the borrower’s discretion if it is determined that an additional interest-only period will be beneficial to the project. Remember that a crucial difference of self-storage development from other asset types is the way that lease-up plays out. For example, an office, multi-family, or retail property can begin preleasing before the project is complete and could reasonably reach stabilization shortly after the project opens. Conversely, self-storage facilities typically do not benefit from extensive preleasing and, because there are so many units and a “net” leasing situation that factors in both move-outs as well as move-ins, lease up to stabilization is protracted and can take anywhere from 24 to 36 months.

A final benefit of the two-step process is a creation of another capital event in the project’s timeline. Despite the additional soft costs, embedded in the incremental loan dollars should be excess proceeds, which provides for a small return of capital to investors earlier in the project, and should ultimately enhance the overall profitability for the developer.

Time Is Money
Time is extremely valuable as a developer; thus, finding a new construction lender for each new project eats away at time that could be constructively spent seeking new opportunities. The example above demonstrates that a two-step financing process can be accretive to the development financing process despite increasing the cost of capital and incurring the associated transaction costs. There is currently an abundance of non-recourse bridge lenders at a time when construction lenders are pulling back, reducing their exposure. Why swim against the tide? Developers with a deep pipeline of projects should consider the efficiencies to be gained from the two-step strategy outlined above. Those with completed projects in lease up or at C/O are in a unique position to take advantage of the non-recourse debt in the market, thereby reducing their contingent liabilities and freeing up their valuable construction lender to undertake the next development waiting to break ground.

Based in Chicago, Shawn Hill is a principal at The BSC Group, where he advises clients on debt and equity financing and loan workout services for all commercial property types nationwide, with an emphasis on the self-storage asset class.