Project funding gaps spell big opportunity for alternative investors
The double blow of rising construction costs and limited supply of senior debt and equity capital is creating project funding gaps in the commercial property sector.
In a bid to secure finance, without capital dilution, developers are turning to alternative financing to bridge this gap. Select non-bank lenders are stepping in to cover the shortfall in a lending space where traditional financial institutions lack the expertise to create specialised loan products for this mid-market segment.
For alternative lenders and investors, this underserviced asset class presents a significant investment opportunity.
Rising rates creating debt shortfall
Prior to the recent interest rate hiking cycle, debt providers would typically have been comfortable providing senior debt to the value of two-thirds of the project, with the balance contributed by the developer in the form of equity. However, due to the hike in interest rates alongside rising inflation and the upward movement of costs – particularly labour and materials – the availability of senior debt and equity capital at a reasonable price has declined markedly.
Alongside rising rates, many senior lenders are holding steady or reducing loan amounts. For some, this is due to the adoption of lower loan-to-value (LVR) ratios, while for other lenders it is the adoption of more conservative property valuations. To obtain more funds from senior lenders, developers must provide additional security, however extra collateral is not always available.
With rising project costs, and without corresponding increases in funding availability, there is now a gap between what developers need and what senior lenders are willing to fund. The result is an awkwardly-sized shortfall funding gap, often an amount not large enough for big players in the market to explore and too big for smaller credit managers to fund. It’s in this gap that alternative lenders, like Jameson TTB, can develop customised finance solutions as the incidence of these shortfalls begin to rise.
The mid-market opportunity
The mid-market sector is the sweet spot for alternative lenders, providing mezzanine, hybrid and structured debt that falls outside the funding by banks and more traditional financial institutions. These lenders specialise in non-standard debt structures and can even collaborate with other credit managers to secure capital with alternative and innovative debt solutions.
The mid-market sector is currently delivering a minimum of low-to-mid teen after-fee returns to investors. Some transactions even extend to high-teens and 20 per cent-plus returns for second-ranking mortgages or where the borrower is happy to enter a profit-sharing arrangement with the lender for the successful delivery of a profitable project. Due to the awkward ticket sizes, mid-market transactions typically command a return premium as they are too small for large global credit managers, but too large for ultra-high-net-worth and family office investors to fund, meaning that the supply of credit in this part of the market is not as plentiful as elsewhere.
An alternative solution
Mezzanine debt sits between equity and senior debt in the capital stack. Raising more equity capital is a potential source of funding, however it is an unpopular move in higher interest rate environments as it can materially dilute existing shareholders’ stakes in the development. Seeking a higher level of senior debt is often not possible due to limits on collateral, plus traditional sources of bank finance can take a long time to secure (up to six months), compared to non-bank lenders where sourcing time is typically around four weeks. When time is money, this ability to bridge a funding gap quickly can be crucial to realising the profitability of a property development project.
Alternative lenders attract investors who have a greater risk appetite but find investment in real estate private credit acceptable due to high returns, stabilising effects on stock-heavy portfolios and asset-backed security. Furthermore, mezzanine, hybrid and structured debt investments sit higher in the capital stack compared to equity investments benefitting from higher repayment priority with comparatively lower levels of risk.
Developer demand for mid-market debt finance is accelerating. In the short to medium term, we anticipate the market will ripen for attractively priced mezzanine, hybrid and structured debt investment opportunities as senior lenders shrink their market share and costs increase.
The investment opportunity is significant. For developers and investors looking to explore alternative credit solutions, it is vital to partner with a trusted manager who has the experience and capital to seize and innovatively finance mid-market commercial projects.
Matthew Afflitto is the distribution director of Jameson TTB.