I have been posting an awful lot on IPOs and S-1 filings, so I thought I would take the time to post on the topic of Financing a Real Estate Deal.
We have been asked by a local developer to put together a small amount of Subordinate Secured Debt for a well known RE development in the area. The project has been in the works for several years and ground has been broken. All of the main equity partners have been in the deal from the beginning and a major financial institution is handling the primary financing. The developer would like an added cash cushion as energy and production costs have risen. The developer doesn't want to hassle with the onerous fees and terms of a bank and so he is trying to arrange some "cheaper" money.
So basically we are putting together an investment group that will loan an amount of money to a developer. The loan or debt is secured by the developer's personal assets including his partnership interests in several other projects. The debt is called "Subordinate" because it does not have seniority in preference compared to other debt holders. What this means that in the case of a default, the holders of "Subordinate" debt are not first in line to receive claims.
We initially tried to negotiate for Preferred Convertible Debt. Preferred Convertible Debt is probably one of the sweetest deals for an investor as it has the conservative component of a Secured Debt with the option to convert that into project equity if the investor desires. Thus if the project doesn't go as planned, the investor can recoup his investment as a preferred debt holder. If the project looks to succeed, the investor can convert into equity and reap the investment multiple of an equity investor.
At any rate, our negotiations for convertible debt failed as the project was very far along and early equity investors would not allow any further sharing of profits. Normally, I would say that Secured Debt, particularly the subordinate kind, is pretty far down the line in terms of desirability. It is safe, but you will not get the outsized gains that a typical private equity investment would give. If your alternative is putting money in a savings account or CD, then it is much better. However, in this situation secured debt financing works very well because the project is very far along and the note is secured. Although it is subordinate, it really doesn't matter as the developer has substantial personal assets so in the worst case scenario the debt can be reclaimed from personal assets. In addition to the high interest rate of the loan, there are transactional fees that will go to the group. The last piece of the puzzle was that we were able to negotiate the developer to give an option for the investor group to purchase first phase units. Given that the project is very desirable and oversubscribed with limited supply, this was of interest to many in the investor group.
I have mentioned before how Real Estate is so much like any other types of Private Equity. When it comes to Financing, this is especially true. Different tiers of debt is seen when structuring a leveraged buyout. Equity is used when investing early into the project. Convertible debt is used in times of great company/developer need. Getting your head around the different types of financing in private equity will definitely make a difference as you put together your RE deal.
Great blog - thanks very much for the insight. Could you comment generally on what the debt-equity split is normally on a real estate deal? If not generally, then any information you can provide would be appreciated. Thank you.
Posted by: Heather Powers | March 11, 2007 at 02:07 PM