With commercial real estate markets still tight, developers are wise to look at different ways of financing projects, says Zachary Darrow, managing partner at law firm DarrowEverett LLP in Providence and a former hedge fund manager.
One option may be a private equity fund, a tool long around but one gaining popularity as developers look outside traditional lending sources. Darrow recently took some time to discuses the funds and the commercial real estate financing world.
PBN: Anecdotally I hear about lower loan-to-value ratios in the commercial real estate market since the financial collapse of a few years ago. Are you seeing this in Rhode Island? Do you know how it compares nationally?
DARROW: We are generally seeing lower loan-to-value ratios on commercial real estate mortgages in Rhode Island – and throughout the United States. We have seen this trend nationally because, to a great extent, the larger players in commercial real estate finance impact all markets.
These larger players have retrenched and now underwrite loans more conservatively, typically lending at lower LTV ratios and requiring greater credit enhancements from borrowers. In recent months, we have noticed such ratios creeping up. However, lenders’ heightened conservatism remains evident.
Although harder hit than many states, the drop in loan-to-value ratios in Rhode Island has been cushioned by factors including its highly desirable geographic features, access to educated workers and competition from new entrants into the local lending marketplace.
Clearly, some states have felt the effects of lower LTV ratios and tighter credit markets more acutely than Rhode Island (e.g., Florida, Nevada, Arizona, etc.). Also, regionally-focused financial institutions stuck with problematic commercial mortgages on their books continue to face significant capitalization issues, particularly in the hardest-hit regions. Such institutions remain reluctant to extend credit to commercial real estate developers without significant equity contributions, if they are willing at all. We have been fortunate in Rhode Island to see strength and a fair amount of activity – albeit predominately conservative – from many of our in-market regional lenders.
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PBN: So with traditional lenders clamping down, where are developers turning?
DARROW: When lenders finance based on lower LTV ratios and other more conservative requirements, developers are generally forced to either contribute more equity to a project’s capital stack, seek alternative financing products, in the form of mezzanine or bridge financing, and/or otherwise enhance lending institution’s collateral, such as via letter of credit or additional collateral beyond the subject project.
Traditional mezzanine financing, pursuant to which ownership interests in the subject property are pledged as collateral for the loan, is more appropriate for stabilized properties that can cover the overall debt service obligations.
Bridge financing, which is customarily for a shorter term than conventional mortgage financing, and may contain slightly more conservative terms in favor of a lender, provides a developer with the ability to carry the subject property for an extended period of time until the completion of a renovation or rehabilitation program designed to enhance a project’s value. A developer’s additional equity comes in the form of personal capital – thus putting its own liquidity at greater risk – unless it can position itself for alternative sources of equity capital.
To avoid overexposure on any one project, many developers form joint ventures with other developers or turn to real estate-focused private equity funds to spread the risk. Taken one step farther, a developer that is a known quantity within the commercial real estate community could launch its own private equity fund equipped with multiple sources of debt and investment capital, a stream of prospective transactions requiring funding and a network of sophisticated contacts.
Private equity funds are nothing new in commercial real estate; however, their size, number and level of sophistication have grown considerably in recent years. Real estate-focused private equity funds have built-in competitive advantages for diversification: One, significant pools of equity raised from many non-traditional market participants (e.g., high-net-worth individuals and institutional investors, as opposed to banks and insurance companies). Two, equity that may be invested in a relatively wide array of available opportunities (e.g., acquiring distressed commercial real estate assets and debt, entering into joint ventures, funding bridge, mezzanine and mortgage loans to developers, etc.). The latter allows fund managers – generally commercial real estate development and finance experts – to move quickly when investment opportunities present themselves.
PBN: What will this mean for developers in Rhode Island?
DARROW: Mezzanine and bridge financing remain attractive options to some developers, depending on the particular nature of the transaction and a developer’s level of comfort with such options, as they are typically shorter-term loans and often have more conservative terms in favor of the lender, as mentioned above.
We also believe private equity capital is an excellent tool in developers’ repertoire, particularly during these challenging times. We do not believe private equity is replacing, for good, the traditional roles of banks and other lenders. However, developers using private equity funds or launching their own are gaining access to larger and potentially more profitable projects and are able to do more of them – all factors that augur for their success. Further, developers partnering with private equity funds will benefit from the experience, contacts and financial resources of the fund and its manager.
Such benefits are neither without cost nor are they one-sided in favor of the developer, however. Developers must seek out competent legal, tax and other professional advisers with experience in these types of deals. Rhode Island’s commercial real estate community is a vibrant one with many strong players, but it is traditionally dominated by local interests.
Access to private equity funds having a regional or even a national focus can be a “game changer” in which opportunities and risks abound. For example, developers using private equity capital must account for often unfamiliar regulatory risks and responsibilities such as record keeping, reporting and other compliance activities. A local developer launching his own private equity fund may be better able to manage such activities with operations on a modest scale.
PBN: Do you think the Dodd-Frank Act will bring greater scrutiny to private equity funds? If so, what will it mean for their future?
DARROW: We are actively monitoring the Dodd-Frank Act’s implementation as well as the Securities and Exchange Commission’s promulgation of new rules under the legislation. There can be no doubt that Dodd-Frank will place greater scrutiny on many areas of private equity fund operations and compliance.
The most significant changes will likely be felt by fund managers, many of whom may face required registration with state or federal regulators depending on assets under management and other factors and, of course, significant record keeping and reporting requirements.
However, we do not anticipate that Dodd-Frank will materially impact the proliferation of these funds or their ability to provide much-needed capital to commercial real estate developers in Rhode Island and beyond. The enhanced regulatory environment demands familiarity with Dodd-Frank and other new requirements and conscientious compliance implementation – whether as an investor, fund manager or developer entering into a transaction with a private equity fund.
PBN: So are law firms like yours viewing private equity funds in real estate deals as an emerging market?
DARROW: Since real estate-focused private equity funds have been around for some time, it would be hard for us to pigeon-hole them as an “emerging market.” We would say, however, that a law firm’s ability to advise clients effectively on these types of deals presents an enormous opportunity – particularly given such funds’ proliferation at a time when traditional financing is relatively scarce and new regulations are changing the capital and credit market landscape. The opportunity is apparent regardless of whether the firm is representing developers or funds in a joint venture or lending arrangement, or fund managers regarding fund formation, capital raising activities, portfolio investments or compliance issues.
We believe private equity funds are here to stay, and that any legal, tax or other firm involved in commercial real estate development or finance will ultimately benefit by engaging professionals with a strong grasp and current understanding of this area of commercial real estate.
