May 28, 2009
Alternative financing can help ease credit freeze
By DENNIS OSTGARD
Schwabe, Williamson & Wyatt
New commercial, residential and mixed-use development has largely stalled in the face of the current financial climate and the associated credit freeze. Alternative financing mechanisms, both private and federally assisted, may work to fund significant portions of acquisition or development costs and thereby bridge the relative unavailability of conventional financing.
Whether these will be sufficient to spur new urban development remains to be seen. However, developers who take the time to understand these tools and opportunities, and add them to their arsenal, are likely to enjoy a competitive advantage in the current market.
It is ironic that most of the financing mechanisms labeled “alternative” actually derive from more traditional approaches than the modern lending programs that are currently in the deep freeze. Seller equity stakes, seller financing, ground leases and assumable financing are four prominent examples. Each has enjoyed periods of prominence in the Puget Sound region, and none have ever disappeared entirely from the scene.
• Seller participation. A simple, yet time-honored mechanism to lessen a developer’s financing costs is to partner-up with the seller. A property owner who desires to improve returns but is not positioned to do so, either due to lack of capital or development experience, may be interested in a partnership in the new project. The favored modern vehicle in our state is the limited liability company. This mechanism has the flexibility of a partnership, combined with liability limitations associated with incorporation.
• Seller financing. If the prospective buyer is unable to secure traditional financing, another alternative is to have the seller finance the sale himself or herself. Under a seller-financing structure, the seller does not receive the full purchase price at closing, but instead receives a down payment and the remainder payable over time. The seller is essentially substituting for the bank for a portion of the project cost.
• Ground leases. As an alternative to purchasing property, developers can make use of a ground lease as a means to gain long-term possession of property without raising up-front the money needed to buy the site from the existing owner. Most often, a ground lease is for a long term, such as 50 or 99 years, possibly with several renewal options.
Ground leases are often used when there are restrictions on alienability of the property. The University Tract in downtown Seattle is a prominent example. The University of Washington manages two long-term leases one with the Fairmont Olympic Hotel and the other with Unico Properties for the university’s 11 acres of land in the center of downtown. But developers can also think of ground leases as an opportunity to finance the land-acquisition cost of a project while reducing the amount to be borrowed for the overall development.
Finding an owner of underdeveloped property with an interest in creating a market return can set the stage for this type of deal.
In 2001, an important innovation in title insurance occurred that makes ground leases in connection with development more viable than previously had been the case. Since that time, it has been possible to obtain leasehold endorsements to American Land Title Association owner’s and lender’s policies to cover capital improvements. This protection is likely key to a lender’s willingness to finance the redevelopment.
• Assumption of existing financing. This mechanism may present itself in connection with existing financing that is assumable by its terms, but more commonly arises as an opportunity in a distressed property workout scenario. In this case, the developer works with an existing lender on the property to revive a non-performing loan as a result of the owner’s financial distress. The lender has an interest in avoiding a foreclosure sale during a period of depressed prices. The developer leverages that interest into an important component of the overall financing of the project. Where an existing mortgage is assumable by its terms, the developer, working with the property owner, may employ the incumbent financing as a piece of the necessary package.
Stimulus bill effects
In February, President Obama signed into law the American Recovery and Reinvestment Act, better known as the stimulus bill. Portions of the huge federal stimulus package target financing for certain categories of stalled “shovel-ready” projects. The federal government has attempted through the stimulus bill to help restore the flow of credit to a variety of development projects, most notably by targeting existing tax credits for affordable housing and economic development bond programs.
• Stalled tax credit projects. A number of affordable housing projects that received tax credit allocations have stalled. Developers have been unable to sell the credits to project equity investors, or face doing so at a price that provides inadequate project funding. The state Housing Commission will receive a large allotment of funds to distribute as outright grants in exchange for return of the unused tax credits formerly granted to projects going back as early as 2007.
As to pending 2009 tax credit applicants and tax credit recipients, a gap-subsidy program will be made available on a competitive basis to close the gap between the anticipated price that equity investors would have paid for tax credits and the much lower present market value.
The details of these programs are complex and still being worked out, but these grants should be an important impetus for at least some of these stalled projects. Washington will receive $43 million in funding to distribute for this purpose.
• Bond Cap Allocation Program. A second financing opportunity in the stimulus bill is the Bond Cap Allocation Program. BCAP allocates authority to issue bonds with advantageous terms either federally tax-exempt or with tax credits to finance projects that include economic stimulus activities. More than $18 billion in bonding authority will be issued nationwide.
The stimulus bill modified the BCAP by broadening the types of eligible projects for which bonds may be issued. Aside from the traditional housing and manufacturing categories that have previously been eligible for these types of bonds, the stimulus bill now allows for tax-exempt or tax-credit bonds to be issued to economic development projects in areas of significant economic distress, and for software or biotech facilities, among other areas. The state Department of Community Trade and Economic Development is tasked with making the initial allocations of the bonding.
The current credit freeze presents a challenging environment for developers. Whether through the assistance afforded by long-established “alternative” private financing structures, the influx of stimulus funds into federal assistance programs, or other enterprising means, informed developers may find means to move projects forward. That would be good news for the broader community.
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