Developers "leverage" lending arms
Equity investors and developers have aggressively stepped up on lending in the past three years to fill gaps that cautious banks won't. They have primarily filled this gap by launching lending arms that are able to provide capital where banks drew the line.
Developers who have created these arms (which are essentially debt funds) are now in positions to secure financing on distressed assets due to the coronavirus. ###
Notable firms: Silverstein, RXR, Related, Trammel Crow Company
A lot of these funds launched in 2018 and haven't deployed their capital, so they're sitting on a lot of dry powder. The current liquidity crunch has presented opportunities for these development lending arms to lend to acquisitions and refinancings at favorable terms.
My opinion:
The fact that developers started launching debt arms to finance their projects may be a testament to the looming credit bubble. As an equity investor in the holding company, I would be concerned with possible conflicts of interest between their development and lending arms. Who knows the risks that some of these shops took to kickstart some projects in terms of overleveraging. It would be naive to suggest that the broader US economy has not also taken advantage of the excessive leverage in the market. We're already seeing the dominos fall in overleveraged industries such as US oil. Although the fundamentals behind owners starting their own debt funds seem to be shotty, it seems to be working out for a select few developers. The risk-reward paradigm at its finest.
I know that firms such as Prudential, who have both equity and debt arms, have significant compliance processes in place to ensure that the equity side isn't tempting the debt side. Does anyone know if these development arms have the same checks?
What sort of conflicts of interest are you worried about?
The fear is that the developer/lenders are less willing to help a sponsor work-out a trouble loan given their ability to step into a troubled project (at a good basis!). What this ignores is structural, fund-compliance issues that may prevent sales between, say, a developer's debt fund and said developer's equity platform. I wouldn't be surprised if there are LPA clauses that mandate arms-length transactions for asset (loan) sales.
That said, we're all big boys here - Don't take loans from developers if you're not willing to accept the risk that they would have no problem stepping into the deal when you hit a snag...
Assuming they are not a loan to own firm, which those firms exist. You need to think about the institutional capital behind the developer. The capital doesn’t want to own these deals, otherwise they would have given the money to a developer to be used for equity. The goal is to get paid a current coupon and get the principal back. The good news is, IF the loan has to be taken back, the developer already develops and it is therefore less risky. With that said, you need to understand the capital behind the developer - they don’t want to own a deal, this changes the timeline and needs of the returns.
I know of at least one developer with a lending arm but their goal is not “loan to own”. The benefit of having a development arm is that they can comp construction costs or overall project viability against their own projects. I imagine regular lenders try to do this too, but I don’t think you can compete with the insight of a development group with local insight into certain markets.
Can’t speak for every development firm with a lending arm, but at least in the group I know, it doesn’t seem sketchy or predatory. Debt funds have been hot the past few years due to HVCRE regulations, so it makes sense that developers use their relationships and experience certain markets to capitalize on that and become a capital provider
Hm, most of the debt funds I've seen aren't financing their own projects.
To the extent you buy their story that they aren't loan-to-own shops (and lets be real here...), the advantage is (as JSmithRE2010 points out) is that developers who also lend have a much better grasp on the actual risks involved in a project. Most construction lenders are reliant on third parties to give them good info - and if you're within a 5-10% margin of error on costs, that can be a huge risk. Developers can drill down much more easily on these numbers, and therefore can take a riskier position in the capital stack with greater confidence.
All that being said, I haven't seen that the NYC community has been particularly successful at this. Obviously firms like Madison have done exceptionally well, but they got in ahead of the game. Everyone and their uncle followed suit when they realized that it was profitable, and more importantly, when their deals started drying up and they needed new sources of revenue.
Speaking from a purely NYC-area perspective, I've noticed a lot of this over the last five years or so. Land and construction costs are so high that developers either need to accept laughably low returns, scale back their business to adjust for fewer incoming revenue streams, or find new businesses in which to expand. We've seen a TON of interest from traditionally-market rate developers who want to get into the affordable space, so they can keep their construction crews working and make some money. Debt funds are just another side to that coin. The crux of the issue is that with all these new guys with experience and access to capital competing, yields there are being driven down and the number of projects relative to the number of players in the space is declining as well. Which is why in all of these spaces, it's the older, more established guys who know the game that are continuing to do better, while the hordes of newcomers languish a bit
I appreciate the comments on the NYC perspective. It seems like these established debt arms are going to make a killing if smaller developers take their financing, assuming that the bumps in the road continue to mount (due to the ripple effects of covid) and they enter in at a lower basis. Thanks for the info.
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