IRVINE, CA—The traditional demarcation line between debtand equity is becoming less clear for a variety of reasons,Landmark Capital Advisors’ president and managing director David Kidder tells GlobeSt.com. With Landmark’s director of business development Tom Farrell preparing to moderate a panel on the blurred lines of the capital stack during the National Real Estate Conference in April 2016, we spoke exclusively with Kidder about this topic and what the real estate industry should know.
GlobeSt.com: How and why is the capital structure changing?
Kidder: There are several forces at work that are causing changes to the traditional capital structure. On the debt side of the equation, the low-interest-rate environment is causing lenders to go further up the capital stack in search of higher yield. For instance, mortgage REITs generally need to pay out a 6% dividend yield at book value, yet is has been difficult to generate that return in a competitive senior-loan debt space. Therefore, they are providing double-digit mezzanine pricing in order to receive a blended return, which meets the yield requirements of their shareholders. On the equity side, investors are seeking more protection by working their way down the capital stack into preferred equity and/or mezzanine positions. This is a by-product of not only where we are within the current real estate cycle, but also due to newer equity funds that have been raised with a more conservative risk-return threshold. As such, we are seeing the traditional demarcation line between debt and equity becoming more blurred.
GlobeSt.com: How should real estate sponsors navigate this issue?
Kidder: There are a few primary implications that sponsors need to consider with this general change in the capital structure:
- Sponsors should become more aware of the capital participants that are providing one-stop debt and mezzanine solutions, (aka “A/B loans,” “senior stretch loans”).
- Sponsors need to gain a firm grasp as to how these one-stop solutions and/or preferred equity tranches should be priced. There is a wide range of potential structures based on ultimate leverage with limited historic waypoints by which to compare and contrast.
- Sponsors need to shore up a stronger liquidity position, either internally or through outside co-investors, since the GP investment requirement per any given project may be three to five times greater than the sponsor co-investment under a traditional pari-passu joint-ventureequity structure. Furthermore, banks are requiring large liquidity covenants for completion guarantees on non-recourse construction financing.
GlobeSt.com: What does this mean for real estate lending moving forward?
Kidder: Moving forward, we see both negative and positive changes that will result from this shift in the capital markets. On the negative front, Basel III regulatory requirements will continue to impact bank lending, both on capital availability and overall expense. Indirectly, this will also impact the mezzanine market and the ability for those participants to secure second deeds of trust. On the positive side, this creates opportunity for non-regulated financial institutions to enter the market and fill the gap of capital requirements that can’t be met by regulated institutions. More importantly on the long-term positive side, this shift provides a better distribution of risk-return for sponsors, investors, and lenders alike, as the capital structure is better bifurcated based on the role of each participant.
GlobeSt.com: What else should our readers know about the capital stack?
Kidder: The changes taking place today are likely part of a multi-year transformation relative to the regulation, transparency and distribution of commercial real estate investments. Since the real estate finance market has a long way to go in sophistication relative to the broader stock and bond markets, there will be complexity and ambiguity that real estate sponsors will need to understand in order to maximize their investment positions. Furthermore, this change in the capital stack may force sponsors to evolve beyond capitalizing projects on a one-off basis, and in turn, focus on the strategic capitalization of the real estate operating platform as a whole.
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