Laura Gonzales, Jacksonville Regional Managing Director/Director of Capital Markets
Developers/owners of commercial real estate (CRE) typically have two types of financing as an option for funding their project(s): debt financing or equity financing. Most developers/owners use a combination of the two. We are seeing an increased need for equity financing in CRE projects today.
The increased need for additional equity is due to many factors including increased costs of the project, higher interest rates, new underwriting requirements for many lenders and/or a desire to keep more liquidity (cash) on hand. Project costs have risen for new developments due to the price increases and availability of materials and labor. The cap rates have remained relatively low resulting in higher costs for acquisition of existing projects and there is flight to quality projects. The Federal Reserve has increased interest rates five times this year by a total of 300 bps (3%) and is expected to raise it another 125 bps (1.25%) by year end due to rising inflation. The underwriting rate for a Bank lender was on average 5 to 5.5% and we are seeing an increase to 6 to 6.5%. Bank lenders were previously funding up to 70-75% of the total cost of the investment project but with the increased interest rates and therefore higher underwriting rates, many of the loans are being reduced to 60-65% of the total cost to hit the minimum debt service coverage requirements. Developers were typically needing 25-30% equity and we are currently seeing that increase up to 35-40% of the project. The cost of capital for other lenders has also increased, which is resulting in less proceeds that the project can support on the senior debt. Many developers/owners are trying to keep cash on hand to help with getting their debt approved and to take advantage of projects that they can purchase quickly and refinance after closing.
At Franklin Street, we are seeing an increase in requests for new equity partners and CRE developers are exploring different equity structures to bridge the gap on the senior debt financing. Equity financing involves selling a portion of the project in return for capital. The two most prevalent equity structures are common equity and preferred equity. Common equity represents investors ownership of an asset. After senior debt and preferred equity are paid, common equity holders receive a distribution of the remaining cash flow or value of the property. Common equity is typically structured as 90/10, 80/20 or 70/30, which means in a 90/10 partnership the Limited Partner (LP) will put in 90% of the equity in the project and the General Partner (GP) will put in 10% of the equity. Common equity investors typically require control of the major decisions and want to receive regular reporting to monitor the project. Preferred equity represents a preferred ownership of an asset because they are paid back an agreed upon preferred return of cash flow after senior debt is paid but before common equity is paid. Preferred equity is typically more expensive due to their privileges of priority return of capital or a higher rate of return than common equity, but they typically receive less control of the project. Preferred equity is sometimes structured as a mezzanine loan which is subordinate to the senior loan but would be paid back prior to the equity holders.
While currently there are many equity groups looking for new projects, their requirements for a sponsor obtaining equity have become more stringent. Providers are looking closely at a sponsor’s experience in the property type and location, the number of projects completed, and the quality and performance of those assets. They are also closely examining a sponsor’s personal financial statements, especially their liquidity and net worth.
Our goal at Franklin Street is to match you with the right partner for your project and to help you through all of the negotiations for structuring and documenting the partnership. Please let us help you finance your project by finding the debt and equity partner for your commercial real estate project needs.