How to Choose Funding

For the distressed-asset investor, simply gaining control of an REO property is a challenge. Portfolio lenders and special servicers have been slow to foreclose and are bringing their REO assets to market. Subsequently, they have created a supply imbalance, which has led to more demand for distressed property. It is not uncommon for quality, core assets to have more than 20 bidders, and it is very common for the winning bid to be all cash. Despite this, some acquisitions are being made with debt and others are leveraging their investments after the close of escrow. Financing for these assets also remains challenging, but depending on the asset and the level of distress some attractive options are available.

I categorize distressed assets in three ways. The first is non-performing and highly distressed requiring substantial capital investment for re-tenanting and deferred maintenance. Without a tenant in tow, securing conventional or bridge financing for these assets is highly problematic. In some instances, we have been successful arranging bank lines of credit to fund TIs and commissions as leases are signed. These credit lines are competitive, roughly 250 to 350 bps over Libor, but require personal recourse and a substantial depository relationship with the institution supplying the credit.

The second category consists of non-performing, mildly distressed assets, including those near stabilization. In this category, due to vacancy and rent reductions, the cash flow cannot service the debt or qualify the asset for conventional long-term financing. For these properties, multiple bridge lending options are available from various institutions including high-yield debt funds and non-recourse bank lenders. Terms and pricing will be structured around the perceived risk and will vary by the location and quality of the asset and the level of distress.

For A and B assets with income sufficient to cover debt service at breakeven or better, some relatively affordable bridge debt is available today. Priced anywhere from 500 to 800 basis points over Libor, these loans have terms of two to three years remaining. With these loans, it is typical to fund reserves for the capital expenses necessary to bring the property to stabilization. For properties that do not have sufficient cash to cover debt service and require a small reserve, similar structured debt is available but the additional risk warrants higher pricing, and the lenders making these bridge loans are pricing their capital with overall debt yields between 10% and 15%. For the large majority of these bridge lenders the minimum loan size is $10 million, and older C-class properties in low demographic markets will typically not be considered.

The third category includes stabilized assets that have become overleveraged through rent reductions and new leasing. Multifamily properties that have recovered from recent occupancy and rent declines also fall into this category. In some instances, the existing lender will offer modified loan terms to a new buyer, but for those looking for new financing, conventional, non-recourse debt is readily available. Today, life companies have increased their allocations substantially for 2011 and are active in even the hardest-hit markets, while CMBS has made a welcome re-entry.

Life companies are, as they have always been, selective when it comes to asset quality. However, leverage is as high as 70% and pricing is in the 5%-to-6% range for 10-year fixed rate debt. CMBS terms continue to improve with each securitization, and today leverage is available at 75% with actual debt-service coverage as low as 1.25X. Some market risk still exists with a CMBS execution, and lenders often require cash-management agreements, independent directors and other nontraditional loan covenants. Of course, Freddie Mac, Fannie Mae and FHA/ HUD are excellent options for stabilized multifamily properties.

For any and all debt transactions today, underwriting is strict. Rents will be written down to market levels, vacancy rates will be applied against cash flow and appropriate reserve amounts will be underwritten, if not always collected. That said, market fundamentals are stabilizing, even improving in some markets, and because of this the lending community believes now is the time to fully re-enter the market, albeit cautiously. For smaller C-quality or poorly located assets, financing is still a challenge and will continue to be until the market is in full recovery. However, for underperforming property with some cash flow in place and performing assets that need recapitalization, there are options and the terms are attractive.

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