Finding Your Path

Who’s Your Lender?

By Brent Rivard, Managing Director

Brent RivardLast year, I wrote an article about navigating the commercial lending environment (“Navigating Today’s Lending Environment”, March, 2014) which had improved from the dog days of the 2009 Great Recession and continues to improve with more financial institutions now willing to lend to a broader array of borrowers today. I also gave some super-secret insight into our debt strategy at Pathfinder – rule #1 being “Match Your Debt to Your Business Plan!” One of the key concepts behind this strategy is to not only pick the right lender, but the right type of lender for your property and plan.

The lending environment has remained strong and, of course, interest rates have remained at all-time lows. Most investors (including those of you who participated in Pathfinder’s informal poll at our annual investor meetings last month) believe that interest rates are moving up later this year, though not in a big way. This means that pricing for borrowers should remain low in the near term. But, it also means that investors looking for yield will have to continue to look somewhere else rather than bonds.

Where have some investors looked for yield in the last few years? Debt funds, of course. According to research firm Prequin, debt funds raised a record $20 billion in capital in 2014, up from $16 billion in 2013. Most of these funds started in the wake of the financial crisis and have been able to operate and lend with less regulation, and more importantly, without the legacy asset problems facing many banks. Institutional investors have become increasingly comfortable with debt fund strategies and where they lend in the capital stack, which has driven more capital into debt funds leading to far more capital available for lending.

DepositFrom a borrower’s perspective, the debt funds have become an increasingly important resource. Since the Dodd-Frank Act and the downturn, the increased regulation and requirements facing traditional banks have caused them to cease or significantly limit lending on certain assets – especially those the regulators perceive carry incremental risk. We’ve had several deals in the last few years that just haven’t fit the banks’ new “box” for lending, and so we’ve turned to debt funds as a viable alternative on those properties. As I said last year, we’re not high leverage borrowers (we keep loan-to-value under 70% and generally stay in the 60-65% range), but even at what we perceive as low leverage, there are some assets that the banks essentially can’t lend on today.

The debt funds are comfortable lending at 70%+ loan to value so, when we come to them with a lower leverage deal, it increases the chance of execution for both parties. In addition, the debt funds are generally more flexible as to terms and can typically close a loan faster than a bank.

Now, all of this comes at a price, of course. The debt funds are generally more expensive than the banks since, they (i) don’t have access to the government’s discount window (i.e. almost free money today) and (ii) are trying to provide that superior yield to investors discussed above. This increased cost comes in a few areas including increased legal fees (many of the funds document the loans in preparation for a securitization), origination and exit fees and a higher interest rate. A few years ago, the spread between banks and debt funds on a pure interest rate basis could be as high as 400-500 basis points, but as the banks have started to lend more in the last few years, those spreads have narrowed to 150-250 basis points, sometimes less. Many of our value-add and opportunistic investments lack the cash flow at acquisition that is required by banks and their regulators for a loan, but when we can get a loan on that same project and pay 5-6%, it makes the debt funds a great alternative. Since we’re planning to dramatically boost cash flow in the first year or two, the loan from the debt fund essentially acts as two-year bridge financing which can be repaid with a less expensive bank loan fairly quickly.
One of the largest differences between banks and debt funds is the recourse (guaranty) element. While some banks have recently loosened their requirements somewhat as it relates to recourse and personal guarantees, most banks require a warm-body guarantor, especially if your relationship with the bank is new. Most debt funds execute loans without any recourse, but are charging more and getting paid for that additional perceived risk.

Here is a brief comparison between the banks and debt funds from a borrower perspective:

Loan Term Bank Debt Fund
Pricing Less expensive More expensive
Leverage Lower Higher
Recourse Generally required Generally not required
Borrower Focused on borrower relationship Focused on real estate and market
Fixed Rate vs. Floating Rate Both available Foating rate only
Mezzanine Financing? No – less aggressive senior loan Yes – Up to 80%-85% leverage

So, for us, the best lender is a function of the business plan. Again, rule #1 – MATCH YOUR DEBT TO YOUR BUSINESS PLAN! Where do we see the lender environment moving over the next couple of years? I believe it depends on two main factors. The first is regulation – the pendulum usually swings too far – which it did after the recession as banks were trying to interpret and apply the new rules. In my opinion, the pendulum has begun to swing the other way as banks understand the regulations more, or the regulators are softening their post-crisis stance. Either way, the increase in non-recourse lending by the banks indicates that pendulum is moving. The second is interest rates. As rates increase and investors can find yield, we believe that the debt funds’ ability to raise record setting levels of capital will diminish and the playing field may become more level. Debt funds are here to stay, though, and have a significant place in the market today and tomorrow.

Brent Rivard is Managing Director, CFO and COO of Pathfinder Partners, LLC. Prior to joining Pathfinder in 2008, Brent was the President of a national wealth management firm and CFO/COO of a one of southern California’s leading privately-held commercial real estate brokerage firms. He can be reached at brivard@pathfinderfunds.com.