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Breaking new ground.

Financing income properties has never been as challenging as it is today-but the opportunities for investors probably have never been better either.

In a difficult environment, strength and knowledge create opportunities. Creative financing techniques can be one of the most important strengths a lender can bring to the table. Understanding the opportunities and why they exist is important in structuring transactions in today's marketplace.

The credit crunch - What happened?

During the 1980s, capital excesses powered an overbuilding boom. Unprecedented real estate investment was spurred by tax benefits. The 1981 Economic Recovery Tax Act spawned the real estate syndication industry, and much of the $50 billion raised through syndication from 1981 to 1986 was driven by tax benefits, not longterm economics.

With the deregulation of the thrift industry, S&Ls sought to enhance earnings through commercial real estate investment rather than by the traditional spreads between long-term assets and short-term deposits. Banks were squeezed out of corporate lending by the commercial paper markets and turned to new markets, including real estate. In fact, real estate accounted for 64 percent of the growth in total bank loans from 1984 to 1989.

During the late 1980s and early 1990s, a dramatic shift took place in the real estate finance industry. Existing sources of financing dried up and underwriting standards became stricter. Long the dominant players in construction and long-term mortgage lending, commercial banks lost ground (literally and figuratively) as their portfolios deteriorated and regulators curbed real estate lending.

As a result, banks are undergoing retrenchment in real estate lending, limiting new business to existing customers, not renewing developers' lines of credit, curtailing construction lending and selling assets to meet. capital requirements. Similarly, the thrift industry faced regulatory pressures that effectively barred thrifts from extending credit for commercial real estate.

At the same time, life insurance companies have been threatened with refinancing risk as five-year bullet loans mature in a more difficult refinancing environment. The result: life companies are requiring more equity and relying on cash flow rather than residual value, or simply curtailing new lending activity. Dramatically fewer funds are allocated to real estate, new deals are based on cash flows rather than values, and the life companies are increasingly selective about borrowers and projects.

Likewise, pension funds have lowered their allocation toward real estate, as disappointment over performance prevails. Individual investment in real estate also continues to drop; capital raised by real estate limited partnerships and REITS fell from a high of $19.7 billion in 1985 to $5.2 billion in 1989.

Overseas, international capital is finding increasingly attractive investment opportunities outside the U.S. Japanese investors are contending with international bank capital constraints, convergence of long-term interest rates and a decreasing trade surplus. European investors are finding more demand for capital at home, with reunification and internal growth underway within Europe. Capital demand in other parts of the world is also escalating in places such as Asia, the Pacific Rim and the former Soviet Republics.

Due to the decline in available capital for real estate, a "buyer-seller" gap developed - our term for the gap in expectations between buyers and sellers that arises when market participants haven't fully adjusted to the new economic environment. Another shortfall we call the "equity gap" also occurred, as lenders began to demand more equity; whereas 90 percent loan-to-value (LTV) ratios were common before, 60 percent to 70 percent LTV ratios are more typical today. The investor has been left to make up the difference in an environment where equity dollars are increasingly scarce.

New opportunities created for lenders

In short, a significant market correction is now taking place - and some effects are positive. Opportunities for strong investors have opened up because of the significant supply of overleveraged real estate assets, an illiquid financing environment and institutional pressures to reduce real estate exposures. Attractive niche opportunities are being created as further market corrections take place.

In 1992, we're seeing the "buyer-seller gap" narrow, as both parties adjust to the new realities. Buyers are focusing on cash flow, not residual value. A buyer's market has grown, as private and governmental institutions are forced to liquidate assets.

In today's marketplace, real estate may be out of favor with many investors - which creates opportunities for those with the ability to evaluate transactions on a case-by-case basis and apply specialized skills.

The following are some observations about the key attributes of the new marketplace for real estate lending and some niches for companies to explore:

* To achieve the strength to capitalize on these opportunities, investors must find ways to overcome the liquidity problems. Creative, innovative financing is crucial. Looking beyond current portfolio problems and real estate exposure and focusing on cash flow-based originations is difficult for many real estate professionals, but it can be the key to taking advantage of the new, rational real estate market that's being created.

* Local market intelligence is another important component. Investors and lenders need to take advantage of favorable risk-reward dynamics; informed decisions can be made only through indepth knowledge of local demographic and economic trends. This need is particularly imperative in markets recovering from economic downturns - only those players with local intelligence can take full advantage of promising opportunities.

Cash flow-based lending helps fuel


Cash flow-based lending has proven to be one of the best financing tools in the current environment. Based on inplace cash flows, attractive floating rates, fast turnaround time and flexible prepayment terms, these loans are especially well suited to acquisitions and refinancings in today's tough marketplace.

Our experience in cash flow-based lending has drawn a specific profile for projects best suited to this financing technique:

* Existing Class A/B income-producing properties, including apartments, industrial facilities, mobile home parks, office space and retail properties.

* Location in a major metropolitan area (defined as an Metropolitan Statis- tical Area of more than 250,000).

* The potential for value creation and/or enhancement is important. In addition, the borrower is usually an entrepreneurial, hands-on manager with a proven track record and local market presence.

Among the most innovative financing programs are those transactions that are structured so that borrower and lender participate in both the risk and the upside potential. Participating loans based on the upside potential of a property can benefit both the borrower and the lender.

Traditionally used by institutional owners to cash out a portion of equity without selling a property, participating loans have moved into a new arena as the credit crunch has ensued. Now, participating loans can be used to finance acquisitions (as either junior or senior debt) or even to facilitate new construction.

For example, a participating first mortgage allows the lender to offer leverage in the 85 percent to 90 percent range in exchange for upside potential resulting from increased rents, reduced costs or escalating demand for a particular property type. The lender will carefully evaluate the borrower's ability to achieve this enhanced value and structure the loan accordingly. Knowledge of local market trends and understanding the borrower's business play key roles in evaluating the value potential.

A participating junior loan also offers maximum leverage in exchange for participation in increased cash flows and/or appreciation. The junior loan would usually be secured by a second mortgage or assignment of partnership interests. Here, 15 percent to 25 percent of the capital structure is funded-effectively filling the "equity gap" caused by declining LTV ratios by traditional senior lenders.

The project profile for the participating junior loan is similar to that for the participating first mortgage: existing Class A/B income-producing properties with significant upside potential done with a borrower with a proven track record of enhancing value.

Participating loans help facilitate new


The participating forward loan takes the concept a step further by funding to-be-built properties that need a takeout commitment. Demand-driven, mid-to-upscale apartment projects, pre-leased retail centers and pre-leased industrial buildings are the prime projects for this type of program. The borrower is likely to be an experienced and financially stable builder with a proven track record and a local market presence.

Heller Real Estate Financial Services has been able to facilitate a number of transactions that illustrate these concepts. Heller Real Estate Financial Services is a division of Heller Financial Inc., a wholly owned subsidiary of the Fuji Bank, Limited.

A recent transaction completed by Chicago-based Heller Real Estate illustrates how a participating forward will work for new construction. The Presidio at Northeast Heights Apartments is a to-be-built apartment community located in Albuquerque. We extended a $10,075,000 forward commitment to help the borrower obtain favorable construction loan terms and provide financing to take out the construction loan. By providing the forward commitment prior to the start of construction, we will receive a participating interest in the value created.

The Presidio property has significant potential for appreciation. The completed project will consist of sixteen, two-story buildings of classic Southwestern architecture, with two-hundred units at middle-range rental rates. The property, located in an infill site with views of the city and mountains, is one of the newest projects in the Albuquerque area since the overbuilding period of the early-to-mid 1980s. The apartment complex will have a broad amenity package including covered parking, heated swimming pool, clubhouse and picnic area. The unit mix of the apartments is superior, containing some of the largest units in the area, as well as desirable three-bedroom units.

The borrower's history also played a role in securing the financing. Trammel Crow Residential had built two properties on adjoining sites during the past three years and sold these for a profit, indicating a very strong track record.

Using participating loans for special

niche opportunities

At this writing, windows of opportunity still exist for special classes of properties. Participating loans offer a viable tool for acquisition of Resolution Trust Corporation (RTC) and distressed-lender assets that have significant upside potential. By acquiring income-producing properties (or loans secured by such properties) at significant discounts to book value, both the borrower and lender can benefit through the use of participating loans.

As an example of Heller's participating mortgage program in this arena, the commitment for a mobile-home park acquisition in New Jersey from the RTC, demonstrates how these elements come together.

This 300-pad mobile-home park is an attractive investment opportunity because it is the only new park in New Jersey, has an occupancy rate of 91 percent, and is located in a growing residential market with significant barriers to entry for future competitive mobile-home parks.

The borrower's business plan is to achieve upside value potential through lease-up of the vacant 27 pads and improvement of the park's common areas. The park was previously owned by the RTC. Heller's flexible $5.5 million financing structure gave the borrower the financial leverage necessary to acquire the park and implement the capital improvements. Heller will be compensated through a participating interest in the property's cash flow and residual value.

This type of participating financing can even be used to provide credit enhancement of tax-exempt development bonds. Originally sponsored by the federal government to finance housing developments, many of these bond issues are associated with projects that subsequently failed to meet income projections, resulting in significantly overleveraged assets and defaults. In order to revive these bonds, based upon today's economics, a replacement credit enhancer is needed.

By providing higher leverage than is currently available in the market, the new party providing credit enhancement can participate in the cash flow and residual value of the property.

For example, our company provided a $26 million letter-of-credit to enhance the refunding of a tax-exempt bond issue associated with an apartment complex located in Denver.

The project consists of more than 650 units and is more than 97 percent occupied. Our firm's letter of credit provided several benefits to the financing structure and ultimately, the owner/borrower:

* Control of the property - Refunding the bonds allowed the owner/borrower to take control of the property from the Federal Deposit Insurance Corporation (the previous owner).

* Low-cost financing - The tax-exempt bond issuance has floating interest rates (including our company's credit enhancement fee) 2 percent to 3 percent below prevailing market interest rates resulting in dramatically reduced debt-service expense.

* Stability - Heller's letter-of-credit provides the necessary support to maintain the ongoing marketability of the weekly adjusted bonds.

In return for providing the credit enhancement, our company will receive a letter-of-credit fee, as well as a participation in the property's cash flow and residual value.

Creative, innovative financing:

Hallmark of the 1990s

The 1990s offer unprecedented opportunities for acquisition and refinancing of income-producing properties. With traditional financing sources fading out of the picture, new variations on the participating programs described in this article will become prevalent. It will become increasingly important for investors to deal with lenders who have the strength and ability to deliver creativity, flexibility and fast response. Joining forces, borrowers and lenders can maximize the opportunities posed by the challenges of the 1990s.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Dennis, Robert
Publication:Mortgage Banking
Date:Jul 1, 1992
Previous Article:Technology.
Next Article:Fundamentals of commercial securitization.

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