Recent banking issues and economic uncertainty have created challenges for the midsize builder to finance its projects. Even as housing demand remains high and supply low, lenders and investors are cautious.
Builders’ constant search to secure funds and fill the entire capital stack has become more difficult. Valuations are unpredictable, lenders say, as they discount market studies and appraisals produced by the best in the business, for both for-sale and build-to-rent. Lenders are being more selective and have reduced funding amounts, no matter how good the evidence and comparables. They cite a need for interest rates to stabilize, and recessionary headwinds to subside.
On the flip side, builders have renewed optimism as homes are selling and build-to-rent projects are renting at a solid pace. The market remains excellent for new homes.
As public builders fund their projects with relative ease and grow market share, the midsize private builder is left to grapple in a financing quandary.
Options Available to Close the Financing Gap
Given today's reality I’d like to review viable options that can help midsize builders fully fund their projects.
The Shift Toward Private Capital Groups
More borrowers are examining the option of private capital, aka debt funds, for multiple reasons. With today’s bank instability, whether real or perceived, debt funds are seeing an influx of loan requests. They provide higher loan-to-costs than banks, higher capacity to one borrower, and have more flexibility in structure. Some offer nonrecourse options and many times you are working directly with fund principals and decision-makers. A higher interest rate is accepted by builders as a trade-off, allowing them to lessen the amount of cash needed for the project.
Mezzanine Debt
Mezzanine debt can provide an additional 5% to 15% of the development project’s total capitalization. Although subordinate to the senior loan, it is senior to all equity. It has a higher interest rate than the senior loan but is a cheaper alternative to raising more equity.
In home building there are niche lenders that will provide this slice of the capital stack. Specialty debt funds as well as some equity investors are willing to go this route. Sometimes debt funds that provide the senior loan can layer in some mezzanine debt within one loan.
Mezzanine debt usually brings the debt up to about 85% loan-to-cost in a stable lending environment. The higher interest rate is a trade-off for more risk due to its second position. Some senior lenders don’t allow mezzanine debt so first make sure it is acceptable.
Preferred Equity
Preferred equity typically helps bridge the gap between the senior loan and common equity. Today, many investors favor preferred equity over common equity as a way to deploy capital. Preferred investors will fund up to 90% of the equity required, receive an acceptable yield, and give up profit potential in order to mitigate some risk. Builders receive the financial benefits of profitable projects without any upside profit sharing. As stability improves in interest rates and valuations, more investors will shift back to their standard business practice of investing joint-venture (JV) equity capital. Preferred equity is in a priority position of repayment to common equity and subordinate to senior and mezzanine debt.
Common Equity (JV Equity)
JV equity is the standard for builders to grow their business. Some large groups have pulled back, while others are able to be selective on deals. JV partners are limited partners, while the builder sponsor is the general partner. JV partners will fund up to 95% of the equity needed in a project, while obtaining a percentage of profits. Like preferred, most common is a 90-10 structure with the investor funding 90% of equity needed and the builder funding 10%.
Return structures vary depending on risk assessment and percentage of equity funded. A smaller preferred return is obtained, which is fixed, and the investor will wait until the end of the project for a waterfall structure to apply. Builders benefit as they are able to minimize their cash outlay per project. Investors like programmatic relationships with experienced builders—a good relationship can mean the world to a builder's growth.
Co-General Partnership
A co-GP relationship allows the builder to contribute less of its own capital while providing enhanced profit participation to the investor. A co-GP investor may also provide balance sheet and liquidity to the partnership for loan qualification purposes while sometimes signing on the loan as borrower/guarantor. Co-GP relationships are generally considered by investors when an opportunistic or outsized profit is anticipated. By offering increased profit potential through a co-GP structure, builders minimize risk and can pursue more projects. A builder general contractor and development fee are essential here prior to profit splits and waterfall structures.
Talk Like a Spreadsheet
Builders need to utilize their development projects as a financial instrument to show investors what key performance metrics they will achieve. Investors want to maximize returns on their capital and want to see the numbers. They make decisions based on spreadsheets and pro formas, given acceptable builder expertise and location. A depth of understanding this and the ability to explain it will go a long way.
Financing projects has become more difficult for private midsize builders. Banks have pulled back, and private lenders have restricted their loan proceeds while becoming more selective. This tightening has created a more arduous task for builders to fund their entire capital stack.
However, with the rise of private capital and equity funds seeking good projects, there are ways builders can bring their capital stack funding to fruition.
