While it may be an Olympic year, sponsors and developers are not ones to play games when searching for funding for their real estate deals. Rising inflation and interest rates coupled with legislative changes have created shifts and challenging hurdles in the real estate industry. Sources of traditional capital are under pressure due to economic uncertainty, and the industry is being forced to explore other funding avenues. Total commercial real estate mortgage borrowing has decreased for a third consecutive year, and calling up your favorite banker may not do the trick anymore.
In this article, we’ll break down the five essential financing options to consider during this season of high interest and economic uncertainty.
1. Traditional Financing
This tried-and-true method of securing commercial real estate funding via funds borrowed from financial institutions has routinely been a viable option for obtaining capital. By financing most of the needed capital, developers can maintain control without needing outside investors. Standard debt also provides a structured and forecastable repayment schedule. However, higher interest rates are causing the cost of capital to become more expensive and deterring some deals. When interest rates were low, lenders competed for the opportunity to lend. High interest rates increase risk for both the lender and borrower, causing fair-weather lenders to exit the real estate space when the market turns.
Commercial real estate borrowing has been in major decline over the past three years. The Mortgage Bankers Association (MBA) reports that in 2023, total commercial real estate mortgage borrowing and lending reached $429 billion, a 47% decrease from $816 billion in 2022 and a 52% decrease from the record $891 billion in 2021. This decline has impacted all asset classes and capital sources, indicating a decrease in borrower demand due to slowdowns in sales transactions and refinances. Property owners who could wait did so, leading to a drop in originations.
Jamie Woodwell, MBA’s Head of Commercial Real Estate Research, stated, “The sustained growth in the amount of CRE mortgage debt outstanding signals that much of the drop in originations was driven by a decline in borrower demand stemming from slowdowns in sales transactions and refinances.”
CBRE Group reports that banks maintained their position as the largest contributors to CBRE’s non-agency loan closings for the seventh consecutive quarter, accounting for 39.5% of the total in Q4 2023, an increase of 38.4% in the previous quarter. In Q4 2023, floating rate loans contributed to one-third of the loan volume, with 38% allocated to refinancings and the remainder supporting property acquisitions.
2. Alternative Financing
Although alternative financing options are challenging traditional commercial real estate lending methods, signs suggest that the decline in standard financing is waning. Hard money loans, also known as bridge loans, offer swift collateral-backed financing for investors. These loans typically have higher interest rates and shorter repayment terms than traditional loans, and they are less regulated to allow for faster processing. While not seen as long-term solutions due to the costs and terms, they allow investors time to coordinate their longer-range financing if needed.
Another alternative is mezzanine financing, which is available for investors seeking a hybrid type of funding that combines debt and equity to provide higher amounts of financial backing than bank loans or asset-based lending. While payment options offered are normally flexible, elevated interest rates mean higher costs. Although not the most advantageous play for the long-term hold, it does allow investors potentially quick processing, but with a side effect of not being as secure as other debt.
3. Convertible Debt
Convertible loans, or convertible notes, allow lenders to convert the debt into equity in the borrower’s property or company. Rather than receiving repayment in cash, the lender can choose to become a part owner of the asset. This arrangement offers flexibility for both the borrower and the lender, as the borrower can choose to repay the loan in cash or convert it to equity.
Convertible debt typically offers lower interest rates compared to traditional financing due to the lender’s potential benefit from the property appreciation through equity conversion. Anticipated property appreciation is a major factor in the application and process of convertible debt. These financing options can help owners avoid diluting their ownership, as the debt can be converted into equity after the property has appreciated, rather than issuing new shares upfront while having a lower value. It is important for the lender and borrower to be aligned in their interests and goals as both stand to benefit from the property’s appreciation.
4. Capital From Investors
Raising capital from investors can be difficult, requiring great salesmanship or an exceptional project. When deal volume was high, finding investors with the funds to invest in deals was plentiful. Obtaining capital from investors typically doesn’t cost the sponsor/developer anything upfront but may lead to diluted ownership or lower allocation of profits. While obtaining capital from investors can be less complicated than securing financing from a lender, dealing with investors can become complex if certain milestones or exits are reached.
To entice investors, some sponsors/developers use preferred returns or complicated waterfall strategies, which may cause different levels of profits to be specially allocated. Private equity firms can also provide capital for larger deals, reducing risk and exposure for individual investors but leading to diluted ownership and loss of control. Crowdfunding is a relatively new funding option that pools money from investors online, reshaping real estate funding. However, the potential for diluted ownership, loss of control, and reporting difficulties make crowdfunding more challenging than it may initially appear.
Let Us Guide You Forward
Navigating the commercial real estate financing landscape can be challenging, but understanding the pros and cons of each option can help investors and borrowers make informed decisions. Ultimately, the choice of the real estate financing option should depend on the specific needs of each project, as well as the goals and risk appetite of each investor and borrower.
Cherry Bekaert can help your company grow and excel, regardless of the economic climate. Our Real Estate & Construction professionals can tailor a strategic plan to your business goals to cover objectives such as effective tax strategies, structuring developments, and profitability analyses. We can provide strong industry relationships while staying ahead of trends to provide timely and actionable advice.
Reach out to your Cherry Bekaert advisor to learn more about how our industry-driven insights can position your business for success.
