Gap financing to the rescue

Form of capital expected to play big role in recovery from credit crunch

Apr.April 30, 2009 07:18 PM

Real estate experts are speculating that some form of gap financing may be integral to the recovery of the commercial mortgage-backed securities (CMBS) market, and ultimately the overall real estate market.

Gap loans were originally used to cover (or “bridge”) the difference between a construction loan and a permanent loan. Then, in recent years, it became common for developers to put up only one small piece of the equity in a deal, with at least one other entity putting up the remainder, or “gap” piece, on top of the senior debt.

Companies have been forming in recent months to provide various forms of gap financing, experts said. For example, Basis Investment Group formed in February as a provider of both gap equity and of mezzanine loans, among other classes of debt.

Mezzanine loans are like second mortgages, where the lender takes over ownership of the property (as opposed to foreclosing) if the debtor goes into default.

Similar gap financing companies have launched as well, though they all seem to be, for the moment, primarily seeking to offer capital for distressed deals, experts said.

“There are funds that have formed to take advantage of the situation, whether it is gap financing or equity acquisitions,” said Frank Sullivan, a principal at Gallin Glick Sullivan O’Keefe, a recently formed, New York City-based real estate consultancy.

Sullivan said he believes that some type of gap financing — which could take the form of second mortgages, mezzanine loans or equity — may be necessary to help pay off billions of dollars of CMBS loans that will mature in coming years.

“The CMBS market is currently gone, so there are no real prospects for replacing it with new issues,” he said.

What’s more, insurance companies and banks don’t have the capital to cover the whole shortfall. “I think the only way this problem can possibly be resolved, since these are all asset-backed loans, is going back to the assets,” he said.

Sullivan said that he believes the present devaluation of commercial properties is not a temporary dip, but a reset, and that some form of gap financing or gap equity will be necessary to refinance the loans.

“Let’s say a property was bought three years ago for $100 million, and it was financed with an $80 million first-mortgage loan, and maybe some mezzanine loans behind that,” Sullivan said. “Today, the property is worth $70 million, and the loan’s coming due. The most financing that’s available today is maybe 50 or 60 percent of the outstanding balance, so you might be able to get $40 to $45 million on a $70 million property.

“So where is the remaining $35 million or $40 million going to come from to repay the first mortgage?” he asked. Sullivan said it remains to be seen what entities will provide the gap financing, but even the government could step into the picture.

“Everybody in the industry is saying, ‘Where is all this money going to come from?’ And nobody knows,” he said. “One possible resolution is for the government to step into the commercial mortgage market and start providing some kind of protection to purchasers of CMBS securities to protect them against default.”

Yet with a dearth of commercial real estate transactions, the current value of many commercial properties has yet to be determined. That factor may keep gap capital on the sidelines, real estate experts said.

“The whole concept of making these gap equities is you start out at one risk profile … and as you move through the term of your loan, the asset increases in value, and the risk profile gets better,” said Paul Fried, a principal of AFC Realty Capital, which has on occasion done gap financing. “It’s very hard to make gap mezzanine loans in an environment where you’re concerned about values continuing to decrease.”

Andrew Oliver, an executive vice president and principal at Cushman & Wakefield Sonnenblick Goldman, a real estate financial services provider, said lenders can try to circumvent that problem by looking at things like cash flow to try to achieve a certain debt yield.

“People are looking at cash flow, which they know is real,” he said. “That’s why a lot of lenders today will make loans basing it on a debt yield of, say, 12 percent or higher.”

Some form of financing will eventually replace the defunct CMBS market, which in part is used to fund smaller deals, Oliver said. Gap financing could serve as that replacement.

“Right now, the money that’s out there is all chasing the best deals,” he said. “So, basically, there’s no money for a deal that’s in a smaller market … Whereas, in the CMBS market, there was money for the smaller markets, the B and C properties.”

However, funds that have provided gap financing for New York City projects in the past all seem to be seeking out the same “distressed deals,” Sullivan said.

Another problem: They’re not finding many.

Stephen DeNardo, a principal at RiverOak Investment Corp., which typically provides $2 to $5 million in gap equity for smaller projects, agreed that opportunities for “distressed deals” of any size have been few.

“There are not a lot of deals getting done,” DeNardo said. “It’s not because there aren’t plenty of funds out there with money to invest. It’s because the assets haven’t been re-priced properly yet, so everybody’s waiting on the sidelines.”

While Fried agreed that gap capital will be essential to any real estate market recovery, he said he doubted it would be the only factor.

“The notion that there are groups focused on that gap and trying to bridge it is a good idea, but the question becomes, can they actually do it?” he asked.

Depending on valuations, gap financing may not be adequate to rescue all CMBS loans, said Richard Bassuk, president of the Singer & Bassuk Organization and chairman and CEO of the Bassuk Organization.

“In some places, even applying very conservative underwriting, you don’t get to a place where putting gap on top of existing [financing] is going to do anything,” he said.

Fried said that, with property values falling, reducing the value of the equity of current ownership, gap capital may become more like equity than debt as it moves up in the capital stack, which could make operators hesitate.

“Is it solving the problem for the current owner, or is it taking advantage of the current changes in the marketplace to effectively become the new equity owner in the asset?” Fried asked.

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