For many years, large commercial buildings worth millions of dollars have been bought and sold through investment vehicles known as real estate partnerships. They are normally structured legally as limited partnerships or limited liability companies.
Typically there is a sponsor that acts as either the general partner or the managing member. These sponsors often are fully integrated real estate companies that find the opportunity; negotiate the property acquisition; place the financing; plan and complete the redevelopment; perform property management; and prepare reporting and accounting, as well as handle other administrative functions.
The sponsor also recruits limited partners or members (the investors) that put up most of the needed equity, which serves as the skin in the game for the debt financing required for the deal. For the most part, the investors are wealthy individuals or companies that are looking for above-average returns. Such entities normally do not have the opportunity to invest in these types of deals on their own.
In recent years, the use of these so-called structured transactions, or syndication deals, has moved further and further down the food chain so that now they are being applied to smaller deals — often under $1 million. This development has increased the risk of having a sponsor that lacks the experience and skills to be successful, which also increases the risk to the investors’ committed equity.
As more investors and developers try to apply this syndication approach to smaller property deals, commercial mortgage brokers should become more knowledgeable about ins and outs of these transactions.
Commercial mortgage brokers should be aware that some of the investor risk associated with structured transactions is mitigated by U.S. securities laws that require investors in these deals to be accredited, which is defined as an investor with a net worth of least $1 million and annual income of $200,000.
Structured transactions offer new opportunities for developers, property managers, mortgage brokers and lenders that deal with smaller commercial property transactions. To enter this growth area of the market, all of the players should understand the rules, the risks, the rewards and the legal rights of each participant in a syndication deal.
The transactions offer a way for skilled developers to leverage their expertise across a larger portfolio of commercial properties and also to increase their fee income as well as their potential for capital gains income. For investors, participating in structured transactions allows them to invest in real estate without direct ownership and the management headaches that accompany it. These structured vehicles also allow investors to enter the real estate market with a smaller cash investment than would be required in a direct-ownership deal.
From the perspective of commercial mortgage brokers, it’s important to realize that more and more of these syndication deals involve smaller commercial properties. This trend is likely to continue. Structured deals facilitate the acquisition and development of many iconic office, apartment and retail buildings in major U.S. cities.
The amount of leverage, or debt financing, in these structured transactions can range from a few hundred thousand dollars to millions of dollars. The minimum investment threshold for investors in structured transactions has declined as more deals have come to market — from a typical minimum investment threshold of millions of dollars to levels now in the thousands of dollars.
The change has allowed developers and managers to apply this financing concept to smaller acquisitions, such as strip shopping centers, small apartment buildings and mobile-home parks. It also has offered a new group of investors the opportunity to enter the investment real estate market.
Breaking it down
Structured-transaction deals follow a similar pattern with respect to commercial property acquisitions. The sponsor finds a property deemed to be managed poorly, underutilized or with subpar rents. The sponsor then forms a limited partnership or limited liability company that buys the property.
Once the sponsor determines the level of debt financing that can be obtained for the acquisition and redevelopment of the property, a decision can be made with respect to how much equity will be needed to fully fund the transaction and complete the capital stack. This process determines how much money the sponsor will need to raise from the investors, which will then be given an opportunity to buy into the syndication deal at a predetermined minimum amount.
In exchange for this investment, the investor is typically offered a priority return (the preferred return), which is paid before any other monetary distributions are made. Any additional cash flow generated from the operations of the property — and/or sale of the property or other capital event — is split between the sponsor and investors.
The sponsor’s goal is to improve the asset through redevelopment, lease-up and/or creating additional value for the site. Once that is achieved, the property is ready for a “capital event,” which could be a refinance or a sale of the property.
These types of structured transactions require financing at two different stages — acquisition and stabilization. This means that a mortgage broker has the chance to earn a fee twice.
The acquisition financing is usually short-term, typically two to three years with opportunities to extend if necessary. The first part of the acquisition loan is for the purchase and a second part for the redevelopment and leasing of the asset. Once the building is stabilized (increased occupancy and market rents), the property is ready for long-term financing.
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Commercial mortgage brokers involved in this business should find lenders that understand the various stages of these structured transactions. Brokers should understand which lenders are best-suited for the initial financing, the second round after stabilization, or both. Brokers also should understand how the redevelopment and operating cash flows work in these syndication deals so a quality marketing package can be put together for the lender.
In addition, commercial mortgage brokers should be careful to work with deal sponsors that are strong and can complete projects. This is important to protect the broker’s relationship with the lending community and to get to the second round of financing.
A version of this article originally appeared in the December 2016 commercial edition of Scotsman Guide.