How to Choose a Capital Provider for Commercial Real Estate

This is an article written by Mike Myatt, President, Pacific Security Capital. www.PacificSecurityCapital.net

 

There was a time when financing a commercial real estate transaction was a relatively simple matter. There were very few lenders to choose from and even fewer choices to make about process and structure. That time has long since past as the number of considerations that must be evaluated when selecting a capital provider are virtually endless.

In order to increase project velocity, improve operating efficiency, conserve internal capital, increase leverage and lower the overall cost of capital it is essential that a sponsor develop an integrated capital formation strategy surrounding acquisition/refinance/development initiatives. Among the many things that commercial borrowers in today�s marketplace need to address when seeking capital are:

• The selection of the appropriate capital provider;
• Level(s) of the capital structure to be addressed;
• Operating considerations;
• Control provisions;
• Rate, term, pricing and structure;
• Closing time frame;
• Third party requirements;
• Certainty of execution;
• Recourse provisions;
• Exit and pre-payment options;
• Inter-creditor or other multi-party agreements;
• Post closing servicing issues;
• The effect of the capital acquired on tax, balance sheet, future projects or portfolio considerations, and;
• A whole host of other value-added considerations.

Possessing knowledge and understanding of the commercial capital markets is a critical factor in not only determining the eventual success of a single transaction but also an entire portfolio or operating business. The first thing that borrowers must understand is that all capital providers are not created equal. There is a definite hierarchy within the world of capital providers and understanding the value-ads offered by different capital providers is important in choosing a relationship.

While many borrowers believe financing to simply be a commoditized offering, the selection of a capital provider should take into account far more than rate and term considerations. In choosing a capital provider, the goal of any borrower should be to develop a close relationship with the firm that can provide not only the broadest access to capital, but more importantly a firm that offers best-in-class subject matter expertise, certainty of execution and as many value-added benefits and services as possible. Capital providers can most easily be broken-down into three groups: Direct Lenders, those that lend their own funds; Indirect Lenders, those that place funds on behalf of others, and; Hybrid Lenders, those that do both.

Direct Lenders

• Investment Banks
• International, national, regional and local banks
• Life Insurance Companies
• Agencies (Fannie, Freddie, FHA)
• Pension Plans
• Real Estate Investment Trusts (REIT)
• Mutual Funds, Hedge Funds, Opportunity Funds
• Credit Companies
• Private Lenders

Indirect Lenders

• Financial Intermediaries
• Investment Advisors
• Syndicators
• Mortgage Bankers 
• Mortgage Brokers

Hybrid Lenders

• Certain Investment Banks
• Certain Investment Advisors
• Certain Banks
• Certain Credit Companies
• Certain Financial Intermediaries

The following analysis of capital providers is not all inclusive, is a high level analysis and exceptions may be found in certain circumstances. While there will always be debate amongst industry pundits and there are certainly pro�s and con�s that can be identified when evaluating any capital provider, all other things being equal it is almost always to the benefit of the borrower to try and have their cake and eat it too when aligning themselves with a capital provider. I have chosen to profile the following genres of capital providers as they are most often accessed by the mass of borrowers in the market place:

• Banks
  Pros: banks are direct lenders and excellent sources for construction/mini-perm financing. They have excellent staffing levels and local market knowledge. Banks have the ability to be very fee competitive when they choose to do so.
  Cons: While more and more banks are developing broader product lines (Agency, CMBS and mezz products) they are new to those product lines and are still primarily construction lenders. Most permanent loans originated by banks are still portfolio loans which mean that they are short term, floating rate, full recourse loans and are therefore rarely competitive. Certainty of execution can often times be an issue due to post acquisition integration issues caused by bank merger mania or the fact that often times the relationship officer dealing with the borrower has no impact on credit decisioning. Other than when dealing with very large banks a borrower may run afoul of geographic, loan-to-one or legal lending limit constraints.
  Conclusion: Most often your best source for construction financing...rarely competitive for other forms of financing.
  
• Mortgage Brokers
  Pros: mortgage brokers are often ex-lenders who have left an institutional environment for the entrepreneurial life. They will often have a solid knowledge of their local market and close relationships with local banks. They will often times engage smaller borrowers, smaller projects or projects that fall outside of traditional underwriting guidelines. Good mortgage brokers can be hard to find, but when you do find them they can be an effective advocate.
  Cons: mortgage brokers are more often times than not smaller, local organizations that do not lend their own funds, and typically have no formal or contractual relationships with direct lenders. They rarely have warehouse or servicing capability and typically have few employees and little invested in infrastructure. While many mortgage brokers attempt to work out of market, they typically don�t have the staffing, market knowledge or capital markets contacts to do so effectively. There is also often times increased fee burden when working with mortgage brokers as they maybe required by the lender to collect their fee from the borrower.
  Conclusion: Make sure that you are dealing with a reputable and experienced mortgage broker. Most often mortgage brokers will be the best option for projects under $1MM in value, projects that have underwriting issues or borrowers that have suitability issues.
  
• Mortgage Bankers
  Pros: mortgage bankers are most times a step-up in the food chain from mortgage brokers. Mortgage bankers are usually very seasoned commercial mortgage professionals. They will usually have more staffing and infrastructure than mortgage brokers. Mortgage bankers will usually possess warehouse and servicing capabilities. Additionally, many mortgage bankers have geographically exclusive correspondent relationships with life insurance companies. Many mortgage banking firms will also have agency, pension and conduit access as well. Most often times mortgage bankers will provide par pricing to borrowers.
  Cons: most mortgage banking firms while larger than most mortgage brokers are still relatively small organizations. While mortgage bankers will typically possess correspondent relationships they usually will not truly be direct lenders. With rare exception most mortgage banking firms are also locally or regionally focused. Most mortgage banking firms will tend to possess more expertise in senior debt and have less expertise and fewer options for structured finance. Very few mortgage banking firms offer professional services.
  Conclusion: since the mortgage banker�s greatest value proposition is usually a correspondent relationship with a life insurance company they will most often use that as their preferred solution and will be most effective when seeking low to moderate leverage non-recourse permanent financing. Note that other lenders such as financial intermediaries and investment banks will also typically have life insurance relationships as well. Furthermore many life insurance companies are moving toward open shops and away from correspondent lending. Mortgage bankers are a viable option for local borrowers with limited needs.
  
• Financial Intermediaries
  Pros: intermediaries are essentially an evolved form of old school mortgage bankers. While most financial intermediaries are not truly direct lenders, they typically possess extremely close capital markets relationships. Unlike most mortgage brokers and mortgage bankers, financial intermediaries often have a national footprint with offices in most major markets. The intermediary may also possess warehouse, servicing, loan sale and brokerage services. Financial intermediaries typically have a better knowledge of structured finance than their banking, mortgage broker and mortgage banker counterparts.
  Cons: most intermediaries are still not direct lenders and offer limited professional services offerings. They have typically grown by merger or acquisition and have many of the same post transaction integration issues as do their banking counterparts. Furthermore there is not tremendous consistency of subject matter expertise or core competencies between offices and the borrower�s fate will largely be placed in the hands of the local office they happen to be working with.
  Conclusion: a very capable and more sophisticated version of the mortgage banker. Intermediaries are suitable options for borrowers needing more expertise or coverage than old school mortgage bankers might offer.
  
• Investment Banks
  Pros: Investment banks typically have an international footprint, offer the broadest access to capital by lending and investing their own funds as well as the funds of other investors and capital partners. Investment banks typically offer the most competitive and sophisticated financing solutions. Investment banks have typically grown on an organic basis which means that they offer borrowers more continuity of process and culture than banks and financial intermediaries. Investment banks have more experience in structured finance than the aforementioned capital providers. Investment banks offer a depth and breadth of subject matter expertise not offered by other capital providers in that they will often times have investment advisory arms, investment sales and professional services groups that will allow borrowers to leverage market research, financial engineering, acquisition and disposition services, construction management, project management and a variety of other value added service offerings.
  Cons: investment banks will often times have higher minimums and more rigorous sponsorship suitability requirements making it more difficult for smaller borrowers or smaller projects to get through the door.
  Conclusion: investment banks provide larger and more sophisticated borrowers with broader access to capital and offer more value-added services than the other capital providers mentioned above. There are rarely sound reasons for a borrower to limit their access to capital, subject matter expertise or value-added services other than lack of access or exposure.

Once a borrower has selected the appropriate capital provider it is essential that the capital provider be engaged as early on, and at as high a level as possible. Experienced sponsors realize the benefit of getting their capital provider involved early on in the planning process. Waiting too long to involve your lender will typically lead to a project built with less leverage and at a higher cost of funds. By including your capital provider in the beginning of the project planning process you will end-up with a project plan that is built around optimizing capital formation leading to greater project profitability.

While architectural and engineering input are critical to a project's success, designing a project to secure the attention of the capital markets is even more critical. If you happen to be working with a capital provider that provides financial engineering or other value-added professional services as part of their engagement your project will likely experience greater velocity, a higher degree of continuity, increased economies of scale and synergy between involved professionals, higher leverage and an overall reduction in cost of funds on the project.

Effectively utilizing the entire capital structure to maximize leverage while achieving the lowest blended cost of funds and isolating risk is essential to the creation of a solid capital formation strategy. In general, the farther you move up the leverage curve utilizing more leverage in the senior position the lower the overall cost of funds will be. Conversely, the deeper you move down the capital stack utilizing mezzanine or equity instruments the more expensive the cost of capital.

Selecting the appropriate capital provider and engaging them properly will aid in the streamlining of the borrowing process. If borrowers will focus on capital formation as a priority at the early stages of project planning the likelihood of increasing profits in a risk managed environment is high.

About Pacific Security Capital: Pacific Security Capital is a leading commercial real estate investment banking firm providing commercial real estate loans, structured finance, investment sales and advisory services. PSC is headquartered in Beaverton, Oregon with other offices in major markets in the United States and the European Community. More information about the company can be found by calling toll-free 800-844-6085 or by visiting the company website at www.PacificSecurityCapital.net.