Types of Capital

DEBT CAPITAL (LOANS)

Bridge

Bridge Loans are commonly used to acquire or refinance properties that need to be repositioned, renovated, reflagged or re-tenanted prior to the property achieving its stabilized occupancy rate.

Hard Money

Hard money loans are commonly used by borrowers when they have a very short timeframe to close a transaction. Hard money loans are also used by borrowers that have credit blemishes who have a hard time getting approved for conventional financing.

Conventional

Conventional loans are commonly used to construct, acquire or refinance properties. Conventional loans have low interest rates compared to other loan products but they are usually full recourse to the borrower and only offer moderate amounts of leverage. Loans are typically provided by a bank, credit union, or other type of savings institution. Conventional loans are good for inexperienced borrowers and small balance loans. However, lenders generally require the borrower to have cash in the deal and maintain strong liquidity post loan closing.

CMBS

CMBS loans are used to finance stabilized properties that a property owner intends to hold for a long time. CMBS is an acronym for Commercial Mortgage Backed Securities. After a CMBS loan is closed, the loan originator contributes it to a pool of other loans that are then bundled together and “securitized.” Securitization, in layman terms, means that the loan pool is figurately chopped up into loan pieces with varying risk and return profiles. The loan pieces are converted into bonds and sold to fixed-income investors. Post securitization, a Master Servicer takes over the responsibility of the loan servicing. The Master Servicer effectively becomes the “face” of the lender that borrowers deal with throughout their remaining loan term. Underwriting requirements are usually less stringent than banks.

Life-Co

Life-Co loans are provided by life insurance companies that want to invest the proceeds that they receive from life insurance premiums into commercial real estate. Life-Co loans are generally used for low leverage transactions on institutional quality real estate that is located around a major metropolitan area. Additionally, Life-Co lenders usually require their borrowers to have very good credit, cash invested into deals, strong liquidity post loan closing, and a favorable track record of real estate ownership.

HUD / FHA

A HUD / FHA loan is a mortgage issued by an FHA (Federal Housing Authority) approved lender and insured by the FHA.  FHA is a federally guaranteed program under the government’s Department of Housing and Urban Development (HUD).  FHA is the not the lender but rather guarantees the loan to a lender.  The lender bears less risk because the FHA will pay a claim to the lender if the borrower defaults on their loan.   FHA loans are available for multifamily and healthcare properties.  

The FHA’s multifamily division facilitates financing for the acquisition, refinance, construction and renovation of traditional and affordable multifamily properties, senior living, cooperatives, student housing, and manufactured housing communities.  Borrowers must have previous FHA ownership or management experience if they are managing the property themselves or they must hire an FHA approved property manager unless a waiver is obtained.  

FHA’s healthcare division facilities financing for memory care facilities, nursing facilities, assisted living facilities and hospitals.  Section 242 facilitates loans for acute care hospitals ranging from large teaching institutions to hospitals in small rural locations. Section 232 facilitates financing for residential care facilities such as assisted living facilities, nursing homes, immediate care facilities and board and care homes. 

An FHA loan requires the borrower to pay two types of mortgage insurance premiums; an Upfront Mortgage Insurance Premium (UFMIP) and an Annual Mortgage Insurance Premium (MIP) that is charged monthly.  The UFMIP is typically equal to 1.75% of the base loan amount. The MIP is typically equal to 0.45% to 1.05% of the base loan amount, depending on the loan amount, length of loan, and the original loan-to-value ratio.  Additionally, HUD insured loans require annual financial audits which may cost upwards of $2,500 per year.  

The process for obtaining an FHA loan is as follows:

1. Choose an FHA approved lender
2. Fill out a loan application and have it reviewed by a HUD Program Center
3. The Program Center reviews the application while FHA does an underwriting analysis of the loan
4. FHA will order an appraisal and an inspection which the borrower is responsible for paying for
5. An FHA mortgage commitment is issued if the loan meets all the program requirements
6. Move towards closing

The most commonly used HUD loan products for multifamily properties are the 221(d)(4) and the 223(f); both of which are summarized below.

CTL

This type of financing is used to acquire net leased properties that are occupied by a single tenant with investment grade credit. CTL financing is most commonly used to create generational wealth. The reason being is that most CTL financing prevents any cash flow from being distributed to the property owner during the loan term. Instead, all cash flow is used to amortize the loan. At the end of the loan term, the property is owned free and clear.

SBA

SBA loans are small-business loans guaranteed by the Small Business Administration and issued by participating lenders, mostly banks.

The business’ net worth cannot exceed $15mm and the average net profit after 2 consecutive years cannot exceed $5mm. The loan structure is typically 50% loan-to-cost from a bank + 40% loan-to-cost from a CDC (Certified Development Company) + 10% cash from the borrower. Under certain circumstances, a borrower may be required to contribute 20% of the project cost in cash. The bank’s collateral is a 1st lien on the property while the CDC’s collateral is a second lien. The terms of the first lien are dictated by the bank. The second lien is usually a 20-year term loan with a fixed interest rate.

The SBA’s 504 Program’s loan proceeds can be used to buy a building, finance ground-up construction or building improvements, or purchase heavy machinery and equipment. Loans cannot be made to businesses engaged in nonprofit, passive or speculative activities.

Generally, a business must create or retain one job for every $65,000 guaranteed by the SBA. Small manufacturers must create or retain a ratio of one job for every $100,000.

For existing buildings, the owner occupancy must be at least 51%. For new construction, the owner occupancy must be at least 60%.

The data above and below is for SBA’s 504 loan program. SBA also offers a 7(a) loan program with loan proceeds up to $5,000,000 that can be used to purchase land or buildings; construct new property; or renovate existing property as long as the real estate will be owner-occupied. 7(a) loans are typically priced as a margin over prime and interest rates may be fixed, variable or a combination of the two. Loans are typically amortized over a 25-year amortization period and loan term.  7a loans are commonly used to flip real estate due to less stringent prepayment penalties than a 504 loan.  7a prepayment penalties are usually 5% of the loan amount in year 1, 3% during year 2, and 1% during year 3.  There is typically no prepayment penalty after year 3. Conversely, 504 loans typically require defeasance.

USDA

USDA loans are business loans guaranteed by the US Department of Agriculture.  The loans are made by lenders, such as banks or credit unions, to businesses in rural areas.  A portion of the loan is guaranteed by the USDA. The loans are like SBA loans but with a focus on promoting small businesses and creating jobs in rural communities.  The loans can be used to purchase, develop or improve commercial real estate. The property must be in a rural area. The borrower must be a US citizen or have permanent residency status and the individuals that comprise the borrower must have a credit score that is 680 or above.  The borrower must contribute at least 10% of the equity for existing businesses and at least 20% for new businesses. The USDA requires a feasibility study by an independent consultant for new businesses.    

Loan terms are negotiated between the borrower and the lender but the USDA does set maximum terms based on how the loan proceeds are planned to be used.  If the loan is used for multiple purposes, the lender can make separate loans or one loan with a blended term.  

The process includes submitting a deal overview to a bank. The bank vets the deal and if it is a fit, they will submit a pre-application to a state branch of the USDA to determine eligibility. If eligible, the state branch will work with the borrower and the bank to complete a full application. The full application is then sent to the national office of the USDA. The national office ultimately approves or rejects the project.

• A business plan
• Personal credit reports of all owners
• Business credit reports
• Resumes of business owners
• Current balance sheet
• Profit & loss statement not more than 90 days old
• Proforma balance sheet projected for loan closing
• Balance sheet and cash flow projections for the next two years
• Number of jobs created or saved and average wages
• Current personal or corporate financial statements for guarantors
• Appraisal
• Environmental report
• Feasibility study by an independent consultant for new businesses

There is no hard rule on job creation. However, the loan application includes a list of the jobs that would either be saved or created with the project. It also includes an analysis of average wages and benefits.

Fannie Mae

This type of capital is typically used to place long-term financing on stabilized multifamily properties that a property owner intends to hold for the long-term. After a Fannie Mae loan is closed, the loan originator contributes it to a pool of other loans that are then bundled together and securitized. Securitization, in layman terms, means that the loan pool is figurately chopped up into loan pieces with varying risk and return profiles. The pieces are converted into bonds and sold to fixed-income investors. Post securitization, the same lender that originated the loan typically services the loan throughout the remaining loan term.

Loans are originated through a DUS (delegated underwriter and servicer). The DUS program relies on shared risk with private lenders providing certainty and speed of execution and competitive pricing. In short, Fannie Mae delegates its lending partners to underwrite, approve and service loans while setting the program underwriting guidelines and agreeing to purchase the mortgage at a future date. Under the DUS, Fannie Mae is neither a lender nor a servicer.

Loans range from $750,000 (under Fannie’s small balance program) to hundreds of millions of dollars.

Freddie Mac

This type of capital is typically used to place long-term financing on stabilized multifamily oriented properties that a property owner intends on holding for the long-term. After a Freddie Mac loan is closed, the loan originator contributes it to a pool of other loans that are then bundled together and securitized.  Securitization in layman terms means that the loan pool is figurately chopped up into pieces with varying risk / return profiles. The pieces are effectively converted into bonds and sold to fixed-income investors. Post securitization, the same lender that originated the loan typically services the loan throughout the remaining loan term.

Mezzanine Loans

Mezzanine loans are used to increase the leverage on a property and decrease the amount of equity required for an investment. The collateral for a mezzanine loan is typically a pledge of ownership interest in the entity that owns the property. Senior lenders are ahead of mezzanine lenders and have first priority to claims against the property.

Preferred

Preferred equity is a form of equity financing that is senior to common equity. It is typically used to reduce the amount of common equity required for a real estate project. It functions like a mezzanine loan but it is usually unsecured. Preferred equity investors usually receive a preferred return on their capital prior to common equity investors receiving any distributions of cash flow. Often times, the preferred return shall accrue on the preferred equity investment so that payments are not due to the preferred equity investor until the property generates enough cash flow to pay the return.

LP

LP equity is an acronym for limited partner equity. LP equity is common equity and is typically invested by passive investors. One of the most common types of LP equity investors are private equity funds that rely on partnerships with local sponsors to execute business plans for their investments. The LP equity investor will provide most of the equity that is required for a project but will rely on their sponsor partner to identify the deal, execute the deal and sell the deal. Despite taking a passive role in the investment, the LP equity investor commonly has control over the joint venture entity that is created to own the property. Usually, the LP equity investor will “promote” the sponsor of the real estate investment by distributing a disproportionate amount of cash flow to the sponsor in an amount that is greater than the percentage of total cash that the sponsor invested into the deal. The “promote” is the sponsor’s reward for successfully executing the business plan for the investment.

Co-GP

Co-GP equity is a form of common equity that is used to minimize the amount of cash that a sponsor must contribute to a real estate project. Often times, a sponsor will structure a 90/10 or 95/5 deal with an LP equity investor. The “90/10” refers to the LP equity investor contributing 90% of the total cash that is required for the deal whereas the sponsor contributes 10% of the total cash. Similarly, in a “95/5” structure, the LP equity investor contributes 95% of the total cash that is required for the deal whereas the sponsor contributes 5% of the total cash.

Co-GP equity minimizes the amount of cash that the sponsor needs to contribute to the “10” or “5” percent slug. For example, if the total cash required for a deal equals $100 and the sponsor structures a 90/10 deal with an LP investor, the LP investor contributes $90 and the sponsor contributes $10. However, if a co-GP equity investment is made, the $10 that is required to be contributed by the sponsor shall be split between the sponsor and the co-GP investor in percentages that are subject to negotiation. In return for making a co-GP investment, the co-GP investor will share in the “promote” that the sponsor receives from the LP equity investor. Additionally, the co-GP equity investor may also share in fees that the sponsor receives from the joint venture with the LP equity investor for acquiring, financing, developing, asset managing, property managing, and disposing of the property. Therefore, a co-GP equity investor will receive a higher return on their investment than an LP equity investor.

ALTERNATIVE FORMS OF CAPITAL

Low-Income Housing Tax Credits

LIHTC is an indirect federal subsidy that is used to finance the construction and rehabilitation of low-income affordable rental housing. The LIHTC subsidies effectively increase developers’ profit on affordable rental housing projects. Without LIHTC, most affordable rental housing projects generate too little of a return to justify investment from developers.

LIHTC provide equity equal to the present value of either 30 percent or 70 percent of the eligible costs of a low-income housing project. To qualify for the credit, at least 40 percent of the project’s units must be set aside for renters earning no more than 60% of the area’s median income or 20 percent of the project’s units must be set aside for renters earning 50% or less of the area’s median income. The rents on the units shall be restricted.

LIHTC give investors a dollar-for-dollar reduction in their federal tax liability in exchange for providing financing (equity investment) to develop affordable rental housing. The LIHTC give investors tax credits that are paid in annual allotments over ten years. The project must satisfy specific low-income housing compliance rules for the full 15-year compliance period. If the project fails to comply, the IRS may recapture previously claimed credits. The property must also remain affordable for at least 30 years.

The Internal Revenue Service allocates federal tax credits to state housing credit agencies based on each state’s population. The state agencies award LIHTCs for qualified affordable housing projects based on point systems reflecting each state’s priorities for the desired type, location and ownership of affordable housing.

State housing agencies administer the LIHTC program. State agencies review tax credit applications submitted by developers and allocate the credits. The IRS requires that state allocation plans prioritize projects that serve the lowest income tenants and ensure affordability for the longest period.

Developers may claim LIHTC themselves or find investors that want to purchase the tax credits. One option for developers is to contribute their tax credits to a syndicator who then pools the tax credits with tax credits from other affordable projects into a LIHTC fund. The syndicator then brokers the tax credits by selling pieces of the fund to investors. The investors receive the benefit of diversification since they are purchasing interests in a fund rather than a single project. Investors may exit the partnership at any time and not face recapture of tax credits if the property continues to operate as affordable housing through the end of year 15.

Historic Tax Credits

Historic tax credits encourage private sector investment into the rehabilitation and re-use of historic income-producing buildings. These federal tax credits allow program participants to claim 20% of eligible improvement expenses against their federal tax liability. The properties must be listed on the National Register of Historic Places.

The tax credits are administered by the National Park Service of the US Department of the Interior and the Internal Revenue Service. These federal agencies partner with state historic preservation officers located in each state.

To receive historic tax credits, property owners must complete a three-part application process. Typically, if developers of historic tax credit projects are not able to use the tax credit, they will raise equity for their project by offering the credits to third parties, including national banks and federal savings associations.

Eligible improvements are called QREs. Examples of QREs include, but are not limited to, the costs related to the repair or replacement of walls, floors, ceilings, windows, doors, air conditioning / heating systems, kitchen cabinets and appliances, plumbing and electrical fixtures, architects’ fees, construction loan interest, and environmental reports.

Crowd Funding

Crowdfunding aggregates relatively small amounts of money from individual investors into a larger pool that is then used to make real estate investments. Most crowdfunding platforms are conducted over the internet. Crowdfunding investments can be made in the form of debt or equity.

PACE

PACE is an acronym for Property Assessed Clean Energy. PACE legislation allows building improvements that result in utility savings to be funded by private capital and repaid via long-term tax assessments.

The mechanism for funding PACE is similar to the way public items such as firehouses and sewers are funded. The costs of those items are passed on to the public and repaid via tax assessments.

With PACE, property owners finance the up-front cost of energy or other eligible improvements on a property and then pay the costs back over time through a voluntary assessment. Eligible improvements include energy efficient improvements such as HVAC, elevators, lighting, solar, plumbing, windows, building insulation and roofing. In some states, PACE can be used to fund a portion of new construction projects if the building owner agrees to build the new structure to exceed the local energy code. PACE can be used to finance nearly all property types, including industrial, retail, office, hospitality and multifamily projects.

Property owners that participate in PACE programs repay their improvement costs over a set period, typically 10 to 20 years.

Typically, the PACE funding is disbursed to the property owner. The property owner then pays contractors to perform the work. Later, the property owner pays the money back via annual assessments on their tax bills. The local taxing jurisdiction then remits the payments that they receive to the PACE equity investors that provided the initial capital.

PACE is only available in certain locations where state and local laws have approved PACE financing.

EB5

The EB5 program was established in 1990 to encourage foreigners to invest in the United States and create American jobs in exchange for a U.S. green card. The foreign national must invest $500,000 in a new commercial enterprise in the United States. Their investment must create 10 U.S. jobs. Starting November 2019, the $500,000 investment amount shall increase to $900,000.

In 1992, as part of the program, EB-5 Regional Centers were created to allow investment funds to be pooled together for larger projects. By pooling funds together, EB-5 borrowers have access to greater amounts of capital and the foreign nationals also benefit because they can count indirect and induced jobs to their job creation requirement. That makes the 10 job creation requirement for the foreign national easier to satisfy.

With the creation of Regional Centers, foreign nationals have two options for investment. They can either make a direct equity investment into a project or they can make an equity investment into a Regional Center.

From a mechanics standpoint, Regional Centers function like debt funds. Foreign nationals make equity investments into the Regional Center’s debt fund. An EB-5 loan is then structured between the Regional Center and the owner of the real estate. The loan is typically a 5-year loan. The collateral for the loan is subject to negotiation and does not necessarily need to be the property itself. Regional centers are usually private, for-profit businesses that are approved by the US Citizenship and Immigration Services, which is part of the Department of Homeland Security.

EB5 investments may only be made in targeted employment areas (TEA), which are usually rural areas or areas with high levels of unemployment.

Deals usually take at least 9 months to close and the money must be invested for a minimum of 4 years. The financing can be assigned to a new owner of a property but it cannot be prepaid.