COVER STORY, OCTOBER 2004

MORE MONEY
Today there is a record number of equity funding options for acquisition, development and recapitalization projects.
Robert Hultslander

Hultslander

With pricing premiums to acquire certain properties in the Southeast at near record highs, the capital markets have become more and more aggressive in placing capital in both new projects and existing assets. Owners and developers today have more equity funding options than ever before, in the form of joint venture equity, preferred equity and/or mezzanine debt, for new acquisitions, development of new or existing projects, or to recapitalize existing properties.

To understand the recent increase in the availability of capital, one must look more closely at the forces affecting the market and the demands and requirements that are being placed on capital sources investing in real estate. Given the state of the investment market and the general positive returns on real estate investments over the last few years, investors (i.e. institutional capital, wealthy individuals, hybrid lenders, etc.) have directed more and more funding specifically targeted for commercial real estate transactions. This surge in available investment capital has placed an even greater burden on those investors looking to invest in new acquisitions that satisfy their yield and return requirements — something that seems to be more and more difficult to achieve in today’s market due to the scarcity of value-priced product.

This high demand and limited supply in the real estate markets has resulted in investors becoming less aggressive in their returns and more creative in placing these dollars. Some investors have looked beyond the traditional straight acquisition and now seek to joint venture with real estate sponsors to either co-fund a new project acquisition or development, or provide funds for existing owners to recapitalize their real estate assets, liquidate a portion of their equity or buy out a current partner. Regardless of the scenario, these investors are participating in more transactions and, in the case where these investors have no real estate management company, are not burdened by managing real estate assets and look instead to the sponsor to provide those functions.

So what does this all mean to the real estate owner or developer? Additional leverage and liquidity. Developers now can find additional equity or bridge/mezzanine debt to help spread risk, expand or increase the leverage of a project. Sponsors looking to acquire an existing property can joint venture with an investor and afford a larger asset. Owners who may have their properties encumbered by conduit debt (and may be prevented from refinancing or taking on additional debt because of prepayment penalties or covenant restrictions) may now have a means of cashing out a portion of their equity by bringing in a preferred equity partner or mezzanine debt provider. The same principle also can allow a sponsor to cash out an existing investor, limited partner or member without having to sell the property. In most cases, the sponsor would maintain control of the property and continue to participate in all the management and leasing fees as the managing member.

These capital sources have various equity and mezzanine structures at their disposal. These investors may now provide as much as 100 percent of the required equity of a project (although 50 to 80 percent is more common) through either a preferred equity or mezzanine debt structure, or a combination of both. In the case of a preferred return structure, the investor owns up to a certain percentage of the asset and is allocated a preferred return from existing cashflow and participates in the upside of the project. In some instances, provisions for a sponsor promote can be structured, where the sponsor can increase his ownership share if certain income or valuation targets are met.

With mezzanine debt, the investor provides a higher-interest loan (usually secured by the interest in the partnership or corporation) to the sponsor, thus increasing the overall leverage over and above the first mortgage. Mezzanine debt may or may not have a fixed rate and may have a back-end accrual or kicker to the investor. The notable differences between the two structures is that a mezzanine structure permits the sponsor to maintain complete control, typically caps the returns to the investor and has a more favorable tax treatment.

Regardless of which option makes sense for the sponsor or developer, what is clear is the increased availability of capital and certain capital sources’ desire to place this money. Perhaps it behooves developers and owners to consider these alternatives while current market conditions prevail, so that they may benefit from the liquidity and increased leverage that these programs provide.

Robert Hultslander is executive vice president of business development for Impressa, LLC, a firm that specializes in equity and debt financing for acquisition, development and recapitalization projects, with offices in Atlanta, Fort Lauderdale, Chicago and Boston.

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