Measuring Money

Malcolm Davies Evaluates the Real Estate Finance Market

Malcolm Davies

George Smith Partners partner Malcolm Davies discussed the direction of the financing market with Editorial Director Suzann D. Silverman. Davies joined the real estate investment banking firm in 2011 having spent 12 years as a real estate developer, investor and capital provider.

Q.You were a developer. What are the prospects for getting development projects financed as the market comes back?

A. I got the last privately financed construction loan in San Diego County when I was a developer in early ’08. … In 2010 and ’11, really all you were seeing in the market was the development and construction of multi-family sites, pretty much in primary gateway cities. Then as you went into 2012 that started to expand into not just primary gateway cities (but) secondary markets, and financing could be done either through banks (or) the FHA and HUD. Today, I’m in the market financing hotels. I will be closing on my first land development loan, which is a horizontal construction loan for retail, hotel, office, multi-family and single-family residential.
So you’re starting to really see an expansion of the development cycle into asset classes that if you were to call a lender a few years ago they would have hung up the phone on you and said, “There’s no way we’re going to be financing speculative land development anywhere in the country.” Today we are doing that. It’s exciting. I think we’re going to see a good five to seven years of the development cycle.

Q. What are some of the most common difficulties that you’re still encountering for developers seeking construction financing?

A. A lot of development companies got in trouble during the recession, so some of the issues that we deal with at George Smith Partners financing our clients are: What were the issues during the downturn? What was their behavior in the downturn? Did they give properties back? Did they work with their lenders? I like to call it, “How many dings and scratches do they have?”
There is more forgiveness now by lenders to work through and understand what those issues were and how they behaved. As long as the development company behaved appropriately, there were many things out of everyone’s control when the market capitulated. So they are much more favorable. A few years ago (they) would say, “There’s not a chance” unless you had sterling credit, a sterling amount of liquidity, a sterling amount of net worth to get a construction loan done. …
It’s more about the reflection of the real estate. There’s real estate, there’s market, there’s sponsorship and then the last kind of solution of that is structure. You can kind of structure around issues with sponsorship groups as long as the real estate is really good. But I would tell you that there is no question that a sponsorship group’s liquidity, their contingent liability and their net worth are really, really key things that the lenders will key in on—and particularly their contingent liability. How much recourse debt do they have out there besides their own construction loan?

Q. How much of a role do foreign investors have now in the U.S. real estate market?

A. A tremendous amount. I think people who are outside the U.S. have a more favorable thought process (relative to) the U.S. recovery than we did. A good example is the deal I’m closing in Maryland for a group based out of Canada headquartered in Calgary. They have $3.2 billion worth of assets under management. They came to the U.S. and bought 50,000 acres of land in 2008 through 2012. That money that they raise is throughout the globe. They have offices in Singapore, Hong Kong and Germany, and all of their investors believed in the recovery of the U.S. real estate market and the economic conditions in the U.S. probably a lot more than we did as Americans at the time.

Q. Have you seen a shift in the balance among the different lender groups?

A.The CMBS market is about as healthy as it has been in years. The pricing is incredibly aggressive. The leverage is about as aggressive as it can get; the appetite is just enormous. The players that are in the securitization market today are very competitive with each other. We at George Smith Partners do a lot of CMBS financing and recapitalization. In that space, we would go out into the market, for example, on a grocery-anchored shopping center, as I’m doing right now. It’s a $10 million (center) anchored by Bond’s. Really, there are about 10 players in the space today. We got quotes from every one of them, and every one of them will call and say, “What is it going to take to get this deal done? How can we get this deal done? How can you select us?”
Is it going to be Deutsche Bank? JP-Morgan? Is it going to be Cantor? I look at that and I think the belief is that the liquidity is back in the securitization market, which means that there are fires on the other side of the securitization, and so they feel aggressive enough that they’re going to go out into the market for what we see. That can be healthy, but I think as everybody knows, we want to make sure that there’s tempered growth in that marketplace. That’s definitely one of the issues that we face.

Q. At this point, what is your expectation for how much of a role CMBS will play?
A. I think it’s going to be huge. I think it’s going to continue to expand and quite frankly be more optimistic in niche markets. We did a CMBS execution on a marina last year. … You wouldn’t have seen that years ago. Now you’re starting to see some of this ancillary type of product; the (pool) buyers are saying, “It’s OK; I understand.” As long as there’s cash flow coming from these assets, they’re good real estate or good locations, they’re there.
The question to me is going to be: How many more groups are going to come in and take the risk to pool assets and securitize them? You’ve got to have a heavy stomach to be able to take that risk and be able to have a strong balance sheet to understand what that risk might be if the buyers of those pools go away. I think that’s going to be why there won’t be as many players rushing back in. The players that are in today are all very strong and healthy and can take that kind of risk.

Q. Overall, are you seeing new products or approaches to financing coming out?
A. One of the things that I’ve been doing with clients to achieve what I like to call a happy medium between a lender’s requirements for a sole personal guarantee and a solution to a full-recourse guarantee loan on a construction loan (is) using liquidity reserves—some percentage of the loan amount that is in essence pledged to the bank or the lending institution. That amount can be flexible. It can be sometimes as small as 3 percent or upwards of 10 percent as an offset to a full guarantee by the borrower. …
Those are the things we work on strategically with banks, with funds, with life insurance companies to help bridge the gap. … What we find is that the lenders love to have this pledged liquidity because it’s an additional element to help service the loan while they figure out what type of other avenues they can take either through appointment of a receiver or bringing in new sponsorship groups that can take over the responsibility of the loan at some point.

Q. What about bridge and other alternative financing? How much are you bringing into deals today?

A. I love bridge. You have different types of bridges out there. You have the type of bridge that says, “We’ll go to a 1.0 debt coverage ratio, allow you to execute your business plan with pretty healthy pricing in the 4 percentile range.” … I have other bridge product—we’re doing a $7.1 million loan on an office building where we’re 90 percent unoccupied at LIBOR plus 625. They’re getting advanced all the TILC money (at) 70 percent leverage. … I call it a “heavy bridge” that’s getting people to execute business plans without it being an equity investment. It’s kind of a quasi-debt position, but they’re taking equity-like risk. The pricing on it I think is very aggressive. You’re also seeing a lot of the Oaktrees of the world launching groups like Sabal, the bridge lending platform, and Sabal is out in the market doing heavy bridge loans. They’re also doing financing for home builders. They’re doing all kinds of different things. I would say that you’re going to see a range of pricing on bridge from 4 upwards to the hard money rates on really opportunistic deals where they’re coming in at 12 percent and they’re lending out 90 to 95 percent of the capital of the sponsorship need. That’s a market that is very strong. …The big question on bridge is what kind of recourse obligations are they looking for. A lot of negotiations we have have a lot to do with recourse. … The one I told you about, the office building, is non-recourse. … That goes to show you how healthy the bridge market is.

Q. Do you see players expanding in that area, and do you see any new types of players in that area?

A. I see it every week. Every week there’s somebody new that’s got some type of new program. I compare bridge in some regard to mezzanine because the same players that play in the mezzanine market that want to get a little bit higher yield are the players that want to get a higher yield in the bridge market.

Q. Overall, how are you seeing financiers react to some of the newly emerging hot investment categories—healthcare, student housing?

A. As a sponsor, I did student housing deals. I love the space. It really is a space that was almost recession resistant because of the universities and the need for housing around universities. It’s still a very strong space. The one thing I would say about student housing is it is so management intensive that nobody wants to lend to anybody that’s a rookie in the space. The same thing with assisted living. Assisted living is not necessarily a real estate investment. It really is an operating management investment. (Lenders) look at that and they say, “I’m not really lending to the guy who is building this asset or buying this asset; I’m really lending this money to the management company that’s going to manage this asset (and from whom) I’m going to be able to get my debt service paid.”
Those are things that (they) are really keying in on, and so what’s important about any of these spaces really is who is the management company, how experienced are they, do they have years and years and years of expertise in the space, and what kind of management expertise do they have?
So you’re finding absolutely that there are large company banks, CMBS—you’re seeing a lot of these guys get into these spaces, but they’re really keying in on it. Of course, it’s more expensive than, say, multi-family assets. There’s going to be a higher spread on a student housing deal than on a traditional multi-family deal. Assisted living is more of a bigger spread.
Healthcare is a really favored asset class. Healthcare is a fantastic asset class. You’ll find it depends on what type of healthcare it is. If it’s a small medical office property with a bunch of different types of small medical users and users that would be looked at more like, maybe, a traditional office building, your pricing might be relative to a similar type of an office building and maybe even better because of the space that it’s in.

Q. What about the refinancing market? How do you see that improving today?

A. It’s really hot. Everybody is looking at something they priced three years ago. Unfortunately, somebody who did a life company execution on a 10-year deal has a significant yield maintenance payment to refinance their 5.5 percent interest rate down to 3.75. They’d save a ton of money, but they can’t because they’ve got a huge prepayment penalty.
You have different reasons for refinancing. What we’re seeing right now is a lot of maturities coming up on vintage loans that were really highly leveraged. One of the things we’ve been doing is using a lot of mezzanine and preferred equity to refinance and execute. Let’s say there’s a $10 million maturity coming up on a Wells Fargo note and the property value is worth $10 million. There’s no senior lender that’s going to lend you $10 million on a $10 million valuation. … We’ll go out and get $7 million from a senior lender—either a life company execution or a bank, whatever it may be—and then we’ll bring in a preferred equity piece of $3 million. The senior pricing would be, let’s say, 3.5 percent and the preferred equity or mezzanine pricing could be as high as 14 percent.
What’s interesting, however, is if you were to look at the blended cost of capital on that refinance, that recapitalization is about the same as what their Wells Fargo note (was when it was) originated seven years ago. That’s why the mezzanine and preferred equity space has been really rampant—they can get current paid 14 percent returns on assets that are performing. Are they taking 100 percent of the valuation equity risk? Absolutely. But I don’t know anybody in the past who was able to get a 14 on current pay. That’s a great piece of real estate and a great deal for that group.

Q. So it sounds like with some of these added layers to the deals more refinancings are able to get done at this point than had been previously.
A. No question. … Today, one of the troubles I’ve had is there are a lot of (tenant-in-common deals) that were structured years ago, and these TICs make it very difficult. … Decision makers and the TICs themselves, the way they’re structured. They’re not a favorable asset class for lenders … so they need to do roll-ups to single-purpose entities and Delaware Statutory Trusts. They’re complicated.