Alternative Lending's New Focus

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When New Boston Fund told Buchanan Partners that it was winding down its position in a three-building, 125,452-square-foot office complex in Gaithersburg, MD, Buchanan faced a dilemma—and one it needed to solve quickly. It needed to find the capital to buy out its partner's share of the property and it needed that capital to be flexible enough so that it could satisfy the terms of the existing mortgage, which Buchanan wanted to keep in place.

It found its solution in Fundrise, a crowdfunding platform for commercial real estate, and quickly raised more than $1.5 million. It was not that the financing was cheaper than bridge capital or other short-term lending, says Colin Dove, project manager with Buchanan. “It was actually comparable with the best rates in the market. But Fundrise allowed us to move very fast and was very flexible in working with the existing lender. That, for us, clinched the deal.” The Washington, DC-based firm is in talks with Fundrise for additional projects now that it has successfully navigated its first endeavor with the platform, Dove adds.

This, of course, is great news for the platform—but the Buchanan deal is important to Fundrise for another reason as well. It was the first time the platform was used to replace institutional capital in a transaction, according to COO Brandon Jenkins.

“We always highlight how Fundrise serves as a substitute for traditional institutional financing and that it is more developer-sponsor friendly,” he says. “So we would always get asked, 'show me deals in which truly institutional capital was replaced by Fundrise.' And we couldn't—until now.”

If the loan amount had been for more than $1.5 million, the institutional players would have been competing fiercely for the deal because of its fundamentals, Jenkins says. “It is a quality sponsor and quality asset that is fully leased and income flowing.” Fundrise investors in the project are expected to receive an annual return of 12% over the projected 36-month term.

Now that the first such deal has been done, Jenkins thinks Fundrise will be called upon more and more to help fill gaps left by institutional capital that are too small for the traditional markets to fund. “That has always been our sweet spot—to be providing money for deals where other players aren't.”

This, of course, is the traditional definition of alternative finance in the commercial real estate space. But Fundrise, and companies like it, are hardly traditional providers.

More familiar lenders in the alternative finance space range from private equity, hedge funds, providers of bridge loans to the high-net worth investor community. The array of tax credits available to mitigate the cost of certain deals—historical, low-income, New Markets—could also be included in the category.

Borrowers, too, tended to follow a certain script, tapping these channels for various reasons. Perhaps they weren't credit-worthy enough for the conduits, life companies or bank lenders. Perhaps their deal was too complex. Perhaps they needed the money within days, not weeks or months. 

These borrowers still exist, of course, but the alternative lending market is changing to target another group: borrowers that can access these traditional channels just fine but want even more flexibility or lower-cost capital. Thus they turn to crowdfunding platforms like Fundrise or another big player in the space, Los Angeles-based Realty Mogul.

In other cases, borrowers are tapping financing sources that are mainstream but not typically used by the commercial real estate community. Specifically, there is a nascent trend developing in the REIT community: accessing the commercial paper market for funding, largely because of its lower cost of capital.

Here's the kicker, though: many of the old rules still apply even when using these new and exciting forms of capital.

And here's another: because these forms of capital are relatively new, they are still subject to change. Maybe as soon as this fall.

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“Each funding source has its place in a capital stack and should be used with care,” says Shahram Siddiqui, a Miami-based partner at Berger Singerman. “When a sponsor is looking at a deal and is asking for advice in how to fund it, one of the first questions I ask is 'what is the expected exit plan and when will that occur?' Each of these capital sources have different requirements and so knowing what you want to do with the asset will allow you to select the best capital source. This also applies to more traditional, larger funding deals.”

For instance, crowdfunding transactions are most often some type of mezzanine or preferred equity deal and not true equity investments. So, it's a short window, likely with a current pay component, and returns are senior to the sponsor, he says.

EB-5 capital is another example of a popular new source of alternative funding. However, it comes with strings attached that could require significant cash to close the deal, Siddiqui says—and the job component makes underwriting a challenge.

More to the point, the US government could change the perimeters of the program come this September.

Joe Sloboda, COO of Miami-based Jafrejo Holdings, knows all that—and doesn't care. Or rather, he is proceeding to use EB-5 money for development until he cannot, because it is simply too profitable and too flexible to give up. “For the next 12 to 18 months, all things being equal, we are going to use EB-5 funding for our real estate projects,” he says.

Jafrejo Holdings is the franchisee of several restaurants, including VooDoo BBQ & Grill and Twin Peaks. It has used EB-5 funds to acquire development sites and existing restaurants over the past few years.

That said, EB-5 is definitely different from more traditional lending sources such as banks or life companies, he says. “If you are used to only dealing with a bank it can come as a surprise the long process of putting a package together, finding investors and getting approval,” says Sloboda. “Typically the process takes a year from start to finish. You put together the offering, take it to the market and raise, say, $12 million. But then it could take months before the money is transferred.”

There are other details, too, that must be considered, including Siddiqui's warning about the job component. “You do have to make sure the investment is within the Targeted Employment Area,” Sloboda acknowledges.

The Targeted Employment Area, or TEA designation, is one component of the program that many believe Congress will change when EB-5 comes up for renewal in September, according to David Cohen, a shareholder at Brownstein Hyatt Farber Schreck in Washington, DC.

There have been concerns by some over alleged gerrymandering with the process and Congress is considering limiting the number of contiguous Census tracts that may comprise a TEA, he says.

In general, oversight has been a central theme of the debate around the EB-5 program, Cohen continues, and it is also very likely that new disclosure requirements will be added for Regional Center operators, and broader oversight authorities will be vested in the Department of Homeland Security to manage Regional Centers going forward.

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Why the tinkering with a program that seems to be working well? Simply put, says Cohen, it comes down to money.

“As the popularity of the EB-5 program has grown in the last few years, so too has the scope of the deals its being used to fund,” he says. There is far more money at stake than there was even a few years ago.”

Indeed there are many major projects that have been funded with EB-5 capital. Tommy Snyder, president of 1619 Capital Partners, points to the Deadwood Mountain Grand, a Holiday Inn Resort in Deadwood, SD. “It started out as just an entertainment venue and through the use of EB-5 lending has turned into a beautiful resort property creating jobs in the state of South Dakota,” he says.

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Higher profile projects include Related Cos.' Hudson Yards, the SLS Las Vegas and Silverstein Properties' 30 Park Place, according to New York City-based Andrew Lance, a partner in Gibson, Dunn & Crutcher's real estate practice. Unfortunately a few high-profile incidences of fraud have occurred as well, he says.

“In the current political climate, and with conservative Chuck Grassley—who has vocally expressed several concerns with the EB-5 program, including national security—replacing fervent supporter Patrick Leahy as head of the Senate Judiciary Committee, Congress is expected to revisit several hot-button topics as part of any program reauthorization,” he says.

The crowdfunding market is undergoing change as well, albeit more from market forces. Commercial real estate crowdfunding platforms are expected to reach $2.5 billion this year, according to the real estate crowdfunding research firm Massolution, following a 156% growth rate in 2014.

As it grows, the model is also morphing. Realty Mogul, for example, recently launched a new commercial lending division. The unit will steer the lending platform into larger loan amounts on commercial properties, according to the company.

Meanwhile institutional capital is flooding the space, says Jilliene Helman, founder and CEO of the company. Many of these institutions do not have their own debt origination arms and are tapping crowdfunding platforms like Realty Mogul to originate on their behalf, she says. “They lean on us to deliver them high quality commercial real estate loans.”

Another interesting play on the institutional side comes from the REIT industry. Recently REIT Magazine, published by the industry association NAREIT, took a look at the very nascent trend of REITs tapping the commercial paper market—so nascent that only two REITs to date have done it.

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In October 2014, Simon Property Group issued commercial paper, and Equity Residential started issuing it in February. The motivation is straightforward: the commercial paper market in general is priced extraordinarily low right now and it is attracting all kinds of new users and uses. Verizon, for example, used the commercial paper market to fund its acquisition of AOL earlier this year—which is rarely done.

Little wonder some REITs decided to follow suit. But it is a bona fide trend? Possibly, says Jason Lail of SNL Financial, but more deals have to be done to judge.

“I have to hand it to Charles Keenan [author of the article]. This was a great bit of insight and analysis on a very new trend that few people have spotted.” Based on the current transactions—admittedly only two—Lail dubs it a trend with legs.

None of this is to say that the traditional model for alternative financing—capital for borrowers or projects that couldn't tap the bank, conduit or life markets for various reasons—isn't alive and kicking. And this model, too, has its new entrants.

Shadow lenders have become a force to watch over the last few years, Siddiqui says. This group is a category of lenders who are not regulated and thus have greater flexibility, he explains. “Most are credit investment funds set up over the past years by opportunistic groups. Some are looking to compete with regulated institutions and others are looking for the deals other groups will not do,” he says. “These groups also tend to have different entry points in minimum loan size, type of collateral and documentation requirements.”

The one common element is that they are expensive. “Because these groups raise funds from investors with looking for 5% to 8% return on their funds, for the credit fund to work after expenses they are typically lending at rates between 11% to 15%, or higher depending on risk,” Siddiqui says.

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“Some folks would call these groups 'loan to own' lenders as the collateral is risky and so they will not lend unless they are prepared to own the asset themselves, if necessary,” he adds. “However, that is a broad brush to use, as in other cases they are simply the capital of last resort.”

There are cheaper sources of alternative capital available, especially if all that is “wrong” with the transaction is that the borrower needs money unduly fast or the project is very complicated.

Elliot Shirwo of the Beverly Hills, CA-based Bolour Associates is one such lender and he points to several transactions that fall into this category. “Just last week, we funded a $5.6-million bridge loan to acquire a 72,776-square-foot industrial building in Fremont, CA, in 3.5 business days,” he says. The borrower had to meet an imminent deadline to exercise his option to buy the property, which he had been leasing, prior to the expiration of this option.

In another example, Bolour Associates funded a land acquisition in East Hollywood. “It was a $5.8-million loan at a 75% LTV, 86% LTC. Our loan will allow the sponsor to complete the entitlement of the property,” he says. Eventually the sponsor will exit out of the bridge loan with a construction loan, he says.

 In yet another example, the company funded a mixed-use development project in Concord, CA. The sponsor needed a bridge loan to entitle the property, to fund architectural plans, and remediate contamination originating from a former dry cleaning operation, he said.

If these transactions sound familiar, that is because in one detail or another they probably are. Such deals have been the heart of the alternative lending universe for years. There is little reason to think demand for such capital will recede.

But, as newer and sexier forms of alternative capital emerge, they will undoubtedly face more competition.