CRE Financing and the Concept of Flexibility – Part 2
In Part 1 of this article, we outlined the concept of flexibility and its importance in regards to the financing of future TI costs. Banks & Credit Unions provide the most flexibility but this comes at the expense of your interest rate, term and recourse level. Conversely, CMBS products and insurance company loans provide lower rates and recourse levels along with much longer terms, however, your flexibility level is considerably less.
We also presented a scenario where you are the owner of a multi-tenant office building, financed with a 20 year fully amortizing insurance company loan. Your building has experienced some roll-over but has secured a LOI for the leasing of this space by a single user at a very attractive base rental rate but they need you to finance $350,000 of TI’s. Let’s explore your funding options for these TI’s:
- 1 – Request Increase from current lender: This is the first call you should always make. Not only will this make them aware of the new lease, you may actually be surprised with the answer. Even with CMBS or insurance financing in place, every deal is different and, while the majority of these of providers will not agree to increases, you never know unless you ask!
- 2 – Escrows: Some lenders require borrowers to fund a monthly TI/Lease Commission Escrow from property NOI. Obviously, if there are enough funds in this account, problem solved! However, issues arise when this account either doesn’t exist or is underfunded because its early in the loan term or the amount of actual TI’s/SF is much greater than that projected when calculating the escrow payments.
- 3 – Refinance: Paying off the current lender and opening a new loan, with a larger loan balance, is always an option. However, substantial pre-payment penalties often take this option off the table quickly.
- 4 – Second Position Financing: A different lender could finance the required TI’s with a loan subordinate to the first mortgage. There are 2 potential sources to consider:
- Bank/Credit Union: The most logical place to start is with the financial institution you maintain your primary relationship with, however, the answer you’ll most likely receive is a resounding “No”. Why? Risk v Return is the answer! Say your existing first mortgage is $3,000,000 equating to a 55% Loan to Value. Why wouldn’t a bank want to loan you $350,000 for an all-in 61% LTV? Because the bank is only being compensated with interest earned on $350,000 but is taking $3,350,000 of risk in order to earn that interest. In other words, the bank would need to repay the first mortgage holder in order to gain control of the collateral in a work out scenario. The ability to access this type of financing was much easier prior to 2008 as the marketplace couldn’t imagine values falling to the point that it wouldn’t make sense for a bank in second position to take out the first. However, the Great Recession taught us that values can, indeed, fall that much and banks wrote off billions in loans such as this and their willingness to provide them has all but disappeared.
- Non-Bank Mezzanine/Private Debt: Non-bank & private lenders have entered this space as they are more willing to take the risk associated with being in a second position but in exchange for a much higher yield. Annual rates between 10%-15% are not unheard of along with aggressive amortization schedules, higher fee structures and the occasional “equity kicker” if the asset is sold during the term of the facility. Of course, as the owner, you will need to look at the blended cost of all financing, along with the economics of the property if you don’t land this tenant, to determine if this solution is worthwhile.
- 5 – Lend Money Directly to the Tenant: Probably the least used option presented herein, but viable nonetheless, is to have a bank lend the $350,000 directly to the tenant. Of course, this option is contingent upon the tenant’s financial capacity and willingness to put this debt on their balance sheet. More than likely, they would seek a discount from the agreed upon rental rate in order to induce them to be your banker!
- 6 – Private Banking Facility: Many financial institutions have “Private Banking” areas which focus on serving the needs of high net worth individuals. Rather than looking only at the specific asset as collateral, these areas would review your entire personal situation in terms of non-CRE collateral as well as total profitability to the bank. For instance, if you happened to have a sizable stock/bond portfolio actively managed by your bank, the fees they earn on that portfolio (in conjunction with the interest earned on the $350,000) may “sweeten the pot” enough for them to lend you the money. In many instances, however, they may look for a pledge or hold on your account in addition (or in lieu of) the 2’d mortgage.
- 7 – Cash: Just as refinancing is always an option to consider, so is writing a personal check to fund the TI’s. Of course, this option is contingent upon your capacity to do so!
As mentioned previously, every deal is different and every provider is different in terms of how they look at things and assess risk. However, the above provides a comprehensive list of your options if faced with an inflexible financing provider. Of course, the goal of these two articles is to educate you on the need to consider future flexibility when initially selecting a primary financing source.
Please feel free to contact the experts at M|GROUP if you have any questions about your commercial or corporate real estate needs. We’re here to help!