How Harbour Opportunity Partners is solving for equity shortfalls in today’s challenging environment
Adapting is commonplace in the world of commercial real estate. With variables in constant flux, we are forced to adapt in how we value, underwrite, and finance the real estate deals we evaluate on a daily basis. This is especially relevant in today’s environment, with tightening fiscal policy deployed to combat inflation resulting in a higher cost of debt across the board.
Despite impaired borrowing metrics, commercial real estate has remained a preferred asset class amongst investors. With limited transactions available to truly gauge the impact of higher debt, cap rate decompression has become prevalent in all asset classes to varying extents, most notably office. Multi-family and industrial assets are still viewed as the most defensive and institutionally desired products. This in part, is due to the long-term, positive outlook for the Canadian economy, with immigration continuing to drive the housing market, and a supply/demand imbalance that will fuel rental growth for the foreseeable future.
With high conviction on the strength of the Canadian economy, and more specifically commercial real estate, the question becomes: How do we adapt for short term variables to achieve a beneficial outcome for long term results? With that in mind, we set out to create a product for borrowers and owners that is relevant in today’s market; Which is how the Equity Recap Program came to fruition.
Lower than expected proceeds, higher than expected rates
For many borrowers it came as no surprise that Canada’s largest banks took a conservative approach to combat the lending risk associated with higher rates. Banks were quick to adjust their loan metrics, namely loan to value and DSCR thresholds, to reduce the risk should an asset value become impaired.
Coupled alongside higher rates, borrowers are now faced with the reality of reduced refinancing proceeds on stabilized, well-performing assets. This is most often the case with borrowers looking to refinance out of their existing bridge or construction loans, a process we know well through our affiliated company Harbour Mortgage Corp. Without sufficient proceeds from term debt refinancing, a borrower is faced with the prospect of having to inject additional equity into the capital stack in order to match the shortfall, which is the exact scenario we envisioned as we worked to establish the Equity Recap Program.
The Equity Recap Program is tailor-made
The key to any successful alternative capital program is flexibility; How to best assist a borrower or owner when conventional capital options fall short. Utilizing preferred equity and mezzanine capital solutions, there are 3 unique and important distinctions of the Equity Recap Program specifically designed for borrowers and owners to utilize upon term debt refinancing:
1. Investment horizon
- Short-term and long-term solutions between 1-5 years
- Pragmatic investment horizon designed to be co-terminus with term debt financing
2. Investment structure
- Flexible to meet a borrower’s cash management needs
- Low current pay rate with a look-back IRR mechanism available
- Preferred equity or mezzanine debt
- On and off-title recourse options
- Security designed to minimize conflict with a senior lender
Where we are seeing traction
Interest in the Equity Recap Program has come from a variety of sources including: mortgage brokers on behalf of clients, lenders with existing loans that are expected to require additional equity upon maturity, and borrowers/owners directly. Unsurprisingly, many inquiries are for development projects that are completed, stabilized, and in the process of refinancing from construction to term debt. With refinancing proceeds unable to fully recapitalize the outstanding balance of the construction loan, the ERP offers a flexible solution by providing preferred equity capital to assist the borrower in achieving cash neutral refinancing while attaining the stability of securing term financing.
In addition to construction projects, we’ve received numerous inquiries from borrowers for value-add projects, multi-family or otherwise, who anticipate an equity shortfall refinancing from their existing bridge loan. Bridging the gap to recapitalization and future debt stabilization are common themes.
Outlook for 2023 & beyond
We firmly believe in the long-term strength and resiliency of the Canadian commercial real estate market. With slower than normal forecasted GDP growth as monetary policy continues to tighten, having a strong balance sheet is vital. Constrained borrowing metrics, reduced liquidity, and the potential for short term asset volatility remain probable in the months ahead. Capital solutions like the Equity Recap Program will continue to play an important role within the market by filling necessary voids in the capital stack, creating strong underlying fundamentals throughout a period of turbulence.