The Old Gray Mortgage: Not What It Used To Be

Investment in commercial real estate has come of age. Once an investment vehicle for a small group of professionals “in the business,” the purchase of, or investment in, non-owner-occupied real estate is now recognized as an investment choice that produces consistent returns in good economic times as well as during downturns.

From high-net-worth individuals to major pension funds, capital is flowing into this sector, and this trend has fundamentally affected the business of lending capital either to develop new projects or to invest in existing properties. In response to this new interest in commercial and multi-unit residential property, savvy capital producers are offering new financial vehicles that go beyond traditional real estate finance.

Developers of new properties that educate themselves in the new options available to them will realize a competitive advantage compared to their peers who only consider traditional mortgage strategies. As capital flows into the real estate sector, transactions are funded using financial vehicles that are increasingly sophisticated and could increase the benefits an investor or developer can harvest from any given project.

As recently as 5 to 10 years ago, funding a new real estate development was typically straightforward. A developer applied for a construction loan, then on completion, repaid the capital provider for that interim loan, and then separately arranged for a permanent mortgage product. However, only once all systems were operational and rent checks had begun to flow, the income stream was secure.

Today, though, many borrowers are taking advantage of new financing methods designed to maximize their return on investment. For example, developers with proven track records and good credit are pre-negotiating financial packages that include both interim and permanent finance for new construction. In this way, they not only lock in interest rates for the permanent finance before a shovel hits the ground, but they are also able to concentrate on the business of development, with the long-term financial details already in place. Capital providers are able to do this type of transaction with their ongoing clients who have proven track records and excellent credit ratings. For these clients who typically have been developing real estate for years, it is a highly advantageous method of financing. New investors may also find that this strategy is available to them, if they serve as financial partners of developers with more experience in the business.

Another innovative product increasing in popularity is the use of mezzanine finance. For an investor in small retail centers or multiple apartment properties, for example, the use of mezzanine equity can triple or quadruple the number of properties in which the borrower can invest. In this manner, that investor can increase their return on investment by a proportional amount—and all for the same up-front commitment of funds.

These two strategies (combined interim and permanent financing and the use of mezzanine equity) are only two examples of the many new financing options available to investors in non-owner-occupied properties. Investors should expect to be able to sit down face-to-face with a single point of contact from their financial institution and discuss what types of financial strategies will best serve them. These strategies are most advantageous to the borrower when more than a single project is considered; the capital provider will be able to help its client best when the client’s short- and long-term financial goals for its company are also taken into account.

For instance, my company typically works with its clients to determine how both short- and long-term needs can be simultaneously satisfied. For a leading developer of multi-unit residential properties, the bank was able to arrange for a line of credit that funded the then-regional developer’s national expansion. Prior to the line of credit, it had funded numerous projects for the developer, from modest single-building projects to those larger in scope like a mixed-use lifestyle center with multiple components requiring cooperation between more than five project lenders.

Additionally, a capital provider should be able to customize financial solutions made possible by the ability to access publicly traded capital markets. The capability to generate commercial mortgage backed securities (CMBS) gives a financial institution financial flexibility and, thus, the ability to structure innovative financial solutions for companies large and small.

The first step to accessing these financial tools is becoming educated on what is possible. This can be done by sitting down with a capital provider to discuss the unique needs of any specific company. Developers and investors should expect their capital provider to take the time to understand their business, and in particular, make recommendations that reflect an understanding of both local market conditions and capital market dynamics. This balance of Main Street values with Wall Street strength allows investors to take advantage of all the new options the flood of capital into commercial and multi-unit residential real estate has created.

This article is reprinted with permission from The Family Business Report sponsored by the Goering Center at the University of Cincinnati College of Business Administration.