No capital, no problem

As the age of cheap money for real estate development threatens to draw to a close, lending without personal guarantees has become coin of the realm in a kingdom where equity partners continue to seek projects even as their expectations for returns shrink by the day.

Inexperienced developers are flocking to the market, and many of their condominium projects lack backup plans to convert to rentals if the buildings don’t sell, a standard practice for project financing in past real estate markets.

Real estate developers who have little or no access to capital to start their project, and even those with no track record, have several options to raise money nowadays. They can go to a lending institution to take on debt, or they can seek out equity partners, who will adopt an ownership stake and mitigate some of the risks, or both.

Developers also can consider taking on mezzanine debt, which can supplement a primary loan, but often with radically different repayment terms. Real estate investment advisers and mortgage brokers can offer guidance to developers and help to minimize their risk.

But the rules of the game have been changing.

“Some lenders are willing to entertain providing loans on a non-recourse basis,” said George Stergiopoulos, director of Cooper-Horowitz, primarily a commercial lender, which also does residential projects and recently financed the Exchange at 25 Broad Street for $75 million. “And that would mean no personal guarantee from a sponsor.”

That does mean making a guarantee of completion and guarantee of interest payments. However, another difference between past lending practices and the current market is most lenders will lend on a condominium project without any assurance that it would work as a rental property.

“Three, four or five years ago, a bank that would lend on a development would always look at a downside rental protection,” said Kenneth Horn, president and principal of developer Alchemy Properties.

“Now they’re banking on the fact that the project will be converted, and they’re not necessarily looking at the fact that they may fail in terms of conversion.”

Banks are still competing for projects, if only sometimes to get excess capital off their books, and are flocking to smaller developers. That doesn’t sit well with larger, more established developers.

“There are a lot of people entering the world of development who have no experience,” Horn said. “That’s not good, because, to a certain degree, a novice enters the field, and banks follow the novice. That’s a recipe for failure.”

But real estate investment banking firms don’t necessarily see the current lending climate as a formula for doom. The types of projects receiving financing are diverse.

Steven Kohn, president and principal of Sonnenblick-Goldman Company, an investment banking firm that lends to residential projects, among others, and financed 1 River Place to the tune of $305 million, said lenders are investing in condominiums because it makes sense. “There are some lenders out there who are very aggressive,” he said. “They will lend very high proceeds at reasonable spreads, based on how much they’re lending. And they’ll base their underwriting on condominium values, not on rental values.”

Kohn said there’s no way a planned condominium that failed could work as a rental at numbers that would satisfy today’s lenders.

Rentals are not feasible at land costs of $300 plus a square foot, he said, so most new condo developments would be unfeasible as rentals.

“What’s changed is the differential between condominium values and rental values,” Kohn said. “It has widened dramatically, so the old analysis doesn’t work anymore.”

Banks using the old rental formula might lend 50 or 60 percent of costs instead of the 80 percent that a bank not requiring a rental backup plan would, Kohn said.

While that may lend some strength to the New York City real estate market in the long run as it takes a turn toward home ownership, Kohn said he wondered where new rental product will come from with the current exorbitant land prices. Still, aggressive lending is not necessarily a bad thing.

“[Aggressive lenders] are going to have to watch their inventory and make sure they don’t get caught if the market turns rapidly, but I’m not sure anyone’s expecting it to turn rapidly anyway,” he said. “If anything it may be a steady slowdown if interest rates keep creeping up.”

One factor driving the rather freewheeling lending climate are footloose mezzanine lenders – those willing to push the envelope on the percentage of a project traditionally financed in excess of 90 percent. But lenders remind skeptics that more leverage could bring a higher return.

“It is a more profitable return. However, it’s a higher risk strategy from an equity player’s perspective,” said Stergiopoulos of Cooper-Horowitz.

A look at how development used to work in one outer borough neighborhood in the 1990s shows how today’s lending climate differs.

Long Island City was not a hotbed of development in the 1990s. But, perhaps in an ahead-of-its-time test of the waters for upscale high rises with striking Manhattan views, a group called The Trotwood Corporation decided to build a 43-story tower there. Developers decided to make a statement and go big with a project called Citylights. Fred Harris worked for them at the time.

“We had to do something different, or nobody was going to move out there, and also, nobody was going to lend us the money,” said Harris, currently senior vice president of development at AvalonBay Communities.

Developers obtained Federal Housing Administration mortgage insurance to ease the way toward getting a mortgage, a key step to making the project attractive to financiers.

“Sometimes it’s about finding the money or the investor or lender,” Harris said. “Other times, it’s really about credit enhancement. If you’ve got the right credit enhancement, it can be about who’s competing to give you the best interest rate.”

The Citylights tower, a risky project in a risky location, got financing at a relatively high interest rate of about 8.5 percent, Harris said. Another issue that cropped up was buyers couldn’t obtain loans to buy the cooperative apartments since the building had too little equity.

That problem was solved when Fannie Mae agreed to insure the end loans, Harris said.
And that breathed life into the project, which is a hot sell in Long Island City today, despite fairly high monthly charges of perhaps $2,200 – much of which is tax deductible – needed to retire the debt. Apartments that sold for $65,000 back in 1997 now have appreciated to such an extent that a two-bedroom was recently listed for $700,000.

“The people who have bought from us are either pretty happy living there or have sold for a profit,” Harris said.