Page 22 - July 5-18, 2023 www.crej.com Finance W e have reached the halfway point for 2023, and what a year it’s been … so far. The first six months of the year brought hasty interest rate hikes, confused capital markets, volatility industry- wide, new lender underwrit- ing parameters, and a lot of unanswered questions about the future. Yet, despite all these factors, lenders who were in the market and active (primar- ily life companies and agen- cies) found a way to get capital out the door efficiently, to get a head start on their annu- al allocations. We were see- ing sales transactions move forward (albeit at lower levels compared to 2022) and had proactive borrowers getting ahead of pending maturities 12 to 24 months out, not knowing what the future held. In addi- tion, after a slow end to 2022, lenders were focused, hungry, and eager to start the year off, for the right deals. Financing activity was relatively elevated given the circumstances, and lenders were able to place dol- lars. That isn’t quite the case anymore. Reality has set in, and finding financing right now, whether it be for construction, acquisi- tion or refinancing, has become more challenging. Sourcing debt isn’t as straightforward as it was, and borrowers can’t get everything they want from just a small stable of relationship lenders. So, what’s caus- ing lenders to pause right now? Let’s look at each source of cap- ital. n Banks. This one is s t r a i g h t f o r- ward. We all know the banking system has been facing extreme scrutiny, especially the regional banks, which represent some of the most active banks in commercial lending. The Fed increasing short-term rates, a lack of payoffs due to lower sales volume, higher reserves for riskier-rated loans and low deposits have all created a liquidity crunch for the bank- ing industry. This slowly start- ed at the end of 2022 but grew exponentially through the first few months of the year. Unless you are a top, long-standing customer, getting accretive terms or even quotes from the banks has become very dif- ficult. n Life companies. Life companies were large bene- factors of banks being out of the market early in the year as they were seen as the best source of liquidity in the capi- tal markets space for develop- ment and existing assets. This lending source doesn’t have to worry about deposits and isn’t as tied to the fed funds rate, so it has more flexibility to continue lending in today’s environment. In addition, life company allocations for 2023 were slightly lower than in 2022 for many lenders, in some cases by even as much as 20%. The pause in the life company space is primarily driven by allocation constraints, and the ability to invest in alternative vehicles, primarily corporate bonds that are yielding strong returns without real estate risk. n Debt funds . Not by choice, but debt funds have had a diffi- cult first half of the year. Ware- house lines were being pulled and became much more expen- sive, and securitizations were few. A combination of these factors (and floating rate indi- ces increasing significantly) have driven their costs so high that making terms pencil for borrowers can be difficult and non-accretive. Spreads are in the 300-500 basis point range, with SOFR now pushing over 5%. With that said, debt funds have significant dry powder to place and are actively trying to get deals done. If borrow- ers have a deal where they can take on a high cost of capital for higher leverage, the avail- ability is there. n CMBS. Conduits have the capital, but their cost of debt with spreads pushing 300- 350 bps over the correspond- ing swaps makes it difficult to work. There have been few securitizations this year and pricing on those remain ele- vated, resulting in higher yield requirements for CMBS lend- ers. A lack of flexible prepay- ment and no direct loan servic- ing make it hard for borrowers to take on this cost of capital, even if they can push loans to value. n Agencies. Agencies are active and trying to get as much business done as possi- ble – a slower investment sales market is the only thing hold- ing them back right now. They are one of the best sources of liquidity for multifamily, and they are only about 33% of the way through their allocations for the year. They can offer rate buydowns, preferential pric- ing for energy-efficient afford- able housing programs and can typically stretch the highest for proceeds and interest only. Another way to illustrate the current environment is by using a recent case study from a financing the Essex team is currently working on. The marketing process included reaching out to 120 different lenders (banks, life companies and debt funds) only to pro- duce four (really 3 ½) quotes on a deal that would have seen 10- to 15-plus term sheets 12 months ago. That is the reality we’re facing right now. So, what is the best way to navigate this current environ- ment? Casting a wider net, being comfortable going out- side of existing lender relation- ships, and considering any and all options if a financing deci- sion is imminent. As mortgage bankers, we are finding our- selves having to double the number of lenders in our mar- keting processes with hopes of getting the same number of quotes, if not less. It takes persistence, having the right relationships and being able to craft the right story to get lenders to the table. Appetite and requirements are chang- ing daily with lenders dipping their toes in and out of the market on a consistent basis – it is important to be up to speed with real-time information on who is active. This could feel a little bit like the dog days of summer for the capital markets world, but we are hopeful that lenders will shift back to their normal hab- its of having a year-end push toward the end of summer. Commercial mortgages are a very important piece of lender investment portfolios, and the overarching demand for more exposure to commercial real estate is still a significant driver despite current economic con- ditions. s pdonahue@essexfg.com Cast a wider net, get creative as lenders slow their pace T he costs for infrastructure have increased steadily in recent years, but the need for development has not slowed, creating a dilemma. Historically, most horizontal infrastructure was funded on a reimbursement basis. The developer would incur the costs upfront, often at very high expense given the early stage of the project, and then seek reimbursement once the improvements were in place. This is even more of a financial risk today with inflation causing proj- ect costs to jump by 20% to 30%. Today, innovative financing struc- tures are necessary to fund these critical improvements to make way for future development and the housing that we desperately need in Colorado. Unlike typical programs where landowners and developers shoulder the upfront costs for construction and await reimbursement, we are now find- ing new ways to creatively issue early stage capital to accelerate development timelines. Over the past decade, we have had significant success capital- izing projects upfront, prior to improvements being in place. Much of this was spurred by the pace of growth in Colorado and investors becoming comfort- able underwriting earlier stage projects given their belief in the growth con- tinuing. This allowed us to begin using a number of dif- ferent financ- ing structures with revenues p r o d u c e d from future development to issue non- recourse, tax- exempt bonds ahead of vertical development. Tax-increment financing has been a commonly used tool across the country, but generally on a reimbursement basis. Our special district group has often found ways to monetize TIF for early stage projects, with a focus on urban areas with blight that lead investors to see the future growth. A prime example is the Fitzsimons Campus in Aurora. This partnership with Aurora Urban Renewal Authority pro- vided additional bonding capac- ity when it was needed most. When a developer wants to pur- sue TIF, it generally is approach- ing a municipality with a plan to improve a blighted area. The case may include a “but for” anal- ysis that says, essentially, “but for you sharing your property taxes, we could not complete this project.” Often the developer is bringing something to the area that the municipality wants, and a negotiation starts from there. When TIF dollars are granted, the municipality/authority will set a “base value,” which is essentially the value of the property today, unimproved or as-is. It then grants the developer the right to some or all of the property taxes above that base value that would otherwise go to the city, county, school district, etc. The developer is incentivized to develop because it gets these revenues that would not otherwise be available. Sales tax is another mechanism that can be used to finance early stage development. This often comes in the form of a credit pub- lic improvement fee, or an add-on PIF. A credit PIF is when the city will lower its sales tax and allow the special district to impose a PIF to effectively share a portion of the sales tax it receives (for exam- ple, the city might have a 3% sales tax and might drop its sales tax by 1.5%, effectively giving the project a 50% share of sales taxes) for a certain period of time. An add-on PIF is a fee charged on sales or services that are taxable beyond what the city/county is charg- ing. This can range from 0.25% to 3% and then can be pledged to bonds. The add-on PIF does not require a city agreement, while the credit PIF does. For developers who are deliver- ing finished lots to builders, there is a tool available that can be quite effective when compared to other sources of early stage capital – special assessments. The land has a lien placed on it that must be cleared prior to sales to a home- owner and provides benefits to developers that include lower rates than traditional bank capi- tal, longer terms than traditional financing, no company recourse and is available at very early stag- es of a project. This generally has lower interest rates than metro district bonds, as they have a lien on the land that investors view as a better credit enhancement. Adding a property tax through a metropolitan district is a com- mon way to fund early stage infrastructure in Colorado. An example would be a 400-home community that will be built out in six years and for which an additional property tax mill levy is applied to these homes. This allows developers to fund things like parks, landscaping, trails, water and roads. Given TABOR in Colorado, municipalities aren’t able to fund these improvements themselves, so rather the users of the improvements (the future residents) pay for the improve- ments over a period of 30 years - a typical example of growth paying its own way. While early stage financ- ing has proved successful and always has a place, its continued use depends on the capital mar- kets to determine interest rates and additional security needed. Today, that occurs when projects wait to borrow until they are at a later stage of the development cycle (still prior to vertical devel- opment), and add additional security by restricting the use of proceeds until a development trigger is hit, some sort of lim- ited guaranty potentially backed by land, higher debt-service coverage ratios providing more cushion for development projec- tions to be slow, and increased developer contributions to the capital stack. All of these items show investors that developers have more skin in the game and are incentivizing them to prog- ress the development. Develop- ment risk is a significant deter- rent to some investors buying early stage debt. Removing any component of that risk through some of these above measures can drive significant investor interest that often results in a successful transaction. s Accelerating development with early stage financing Paul Donahue Vice president, Essex Financial Group Shelby Noble Managing director, Piper Sandler Special District Group