INTRODUCTION

Within the real estate capital industry, deciding equitable fee sharing arrangements is often one of the more debated issues between various professionals involved in structuring a specific transaction.  Not to be confused with overall fee structuring, this discussion is completely separate from the actual negotiations with the property owner (e.g., exclusive vs non-exclusive and pricing).  Otherwise known as “fee distribution”, “splits” or “co-brokerage” agreements, fee sharing arrangements cover all types of real estate capital activities including consulting, sales, financings, partial-equity and joint venture assignments.

Fee sharing discussions don’t apply to certain situations, including smaller fees and individual assignments.  Although no fee is too insignificant, for smaller fee assignments that are typically $25,000 or less, fee sharing arrangements are more casual as the depth and scope of such assignments seldom require multiple disciplines.  These fee sharing arrangements are usually more standardized.  Also, capital transactions limited to single individuals and organizations may be irrelevant or subject to internal compensation policies.

Fee sharing discussions are usually structured based upon rules of thumb.  Brokers, investment analysts, administrative personnel, closing professionals and others within an organization — as well as outside parties involved in a transaction — will each have individually-biased views on fee distributions. Such discussions typically lead to heated debates on “fairness”, “reasonable”, “standard”, “market rate”, “customary” and “typical” as defined by each party.   Of course, everyone normally believes that their position is “right.”

THE FAIRNESS DOCTRINE

Rather than debating about right or wrong, or what is considered fair, fee sharing discussions need to center around facts and circumstances.  To avoid conflicts, each party should agree beforehand about the “fairness” of the fee sharing allocations based on determining responsibilities and dedicated resources.  

Needless to say, defining “fairness” in fee sharing arrangements is both an art and science.   The science identifies specific variables in the fee split equation; the art applies the importance of the variables using weighted averages.  For instance, how much importance does experience and market knowledge factor into calculating an individual’s contribution to the transaction?

More often than not, fee sharing agreements are blended with management policies, experience and instinct — normally resulting in “fair” distributions. In most instances whereby fee split allocations are not deemed fair by all parties, conflicts will develop. Therefore, the goal of fee sharing arrangements, like any other business ventures, is based on an equitable “win-win” outcome.

For all parties to view the process as completely fair and unbiased, experience and instinct should be supported by applying clearly defined criteria measuring personnel contributions to the entire real estate capital placement process.  Control and Placement are the two such components forming the basis of measuring time and resource allocations in this process.

CONTROL AND PLACEMENT – THE FOUNDATION OF FEE SHARING DISCUSSIONS

Fee sharing based on fairness guidelines are rooted in Control and Placement.  These two components equally form the balancing point of fee distribution. Control focuses on capturing a real estate capital placement opportunity such as a project sale, mortgage origination or joint venture.   Placement forms the counterweight for successfully completing a funding assignment.  Said another way, Control represents the capturing the opportunity and Placement converts the opportunity into a successful transaction.

Understanding Control and Placement is relatively simple. However, identifying the various components and subcomponents can become a daunting task.  And more often than not, Control and Placement will be interrelated as elements within each of these components mesh together to make the process successful in totality rather than piecemeal.

Control and Placement discussions assume all parties involved in fee sharing discussions are professionally qualified and licensed.  For example, an individual with accounting and real estate analysis software training should be responsible for project cash flow analysis.  Before any sharing arrangements occur, parties must be properly licensed to conduct business and collect fees in the various States where projects exist.  Typical licensing requirements include sales brokerage, appraisal and loan origination.  Otherwise, any agreements are not legally enforceable, regardless of professional qualifications and Control/Placement responsibilities.

In addition to the qualifications and licensing requirements, three other factors to consider in formulating Control and Placement responsibilities to additional professionals while insuring that the client’s best interests are served include:

• Outsourcing services to professionals with specialized expertise for document reviews, physical inspections and demographic reports
• Portfolio vs. single-asset assignments
• Project timelines – how quickly does the assignment need to be completed

While few professionals actually break down fee arrangements using such components, more disciplined approaches to these decisions rely upon identifying various subcomponents and applying formulas for calculating contribution/compensation levels apportioned to all parties involved in the transaction. The CAP Fee Sharing Model is one such tool used for identifying and quantifying contributions with the goal of computing fee split allocations to all parties involved in the transaction.

FEE SHARING CALCULATIONS

Realty professionals will certainly have different definitions of how to identify and weight Control and Placement, or other variations of these components.  As a result, The Real Estate Capital Institute interviewed a wide spectrum of industry leaders in the debt and equity capital markets including investment sales specialists, consultants, mortgage bankers and other brokers for the purpose of creating a fee distribution model that reasonably and accurately reflects Control and Placement measurements, resulting in the CAP Fee Sharing Model.

The CAP Fee Sharing Model demystifies the process of systematically computing equitable fee splits.  As mentioned earlier, this model centers on Control and Placement for quantifying fee sharing arrangements.  The goal of this model is to generate interactive fee sharing calculations based on “Win- Win” objectives for all parties.  The calculations require applying weighted-averages to important tasks within the process.

The Model divides Control and Placement on a 50/50 basis, further subdividing these components into subcomponents along with assigning weighted averages.  Control/Placement is a straightforward computation since both components carry equal weight.  Measuring subcomponents is a more challenging task as their respective values are more subjectively analyzed.  Regardless, the modeling formulates a basis for further discussion of the value of services provided by the various parties in the capital placement process. 

The Control variable is subdivided into three components: Referral/Generating Leads, Handling Client Communications and Procurement of Exclusive Agreement — accounting for half of the total fees.  Placement, the other half of the fee split calculation, includes Underwriting, Marketing and Closing subcategories.  Each of these major components and their respective subcomponents are further outlined below, including definitions and weighted average values in relationship to the entire fee.

CONTROL

Control is defined as the ability to secure a transaction for capital placement including sale, refinancing, joint venture, etc. The control results collected efforts in negotiating the agreement (mortgage banking application, exclusive sale agreement).  Control is not necessarily limited to a single individual or organization and often involves multiple groups of professionals, depending upon the scope of the capital placement assignment. 

The key subcategories of Control include: Generating Leads, Handling Client Communication and Procuring an Exclusive. These Control subcomponents are presented in sequence of a typical transaction beginning with identifying the project through obtaining an exclusive.

Referral/Generating Lead (10% of Total Fee):  Generating leads and mining for new client relationships is the initial step necessary in initiating a transaction. Cold-calling is the most common method of finding leads. Attending various real estate seminars and conventions, actively participating in professional organizations and other more effective methods of meeting clients also produce effective results. Regular follow-up based on additional meetings, phone calls, e-mailing campaigns provide continuous links of communication. In some cases this process may take days, months or even years. This activity has a value of about 10% of the entire transaction, and is typically known as a “referral fee” if no other action is taken by the broker involved in the process.

Handling Client Communications (10% of Total Fee):  Naturally speaking, client communications on an ongoing level take the referral process to the next level.  More frequent communications help to establish stronger links with the client, requiring more time and energy, as well as information gathering and analysis work to secure project control. As with the referral process, client communications can be an ongoing situation spanning a long time period. Handling communications is typically interwoven with the referral process and accounts for a total of at least 20% of the fee. 

Procuring the Exclusive (5% of Total Fee): Procuring the exclusive is the final step in successfully establishing project control.  Securing the exclusive, whether a loan application or a listing agreement, indicates that the referral process and client communications have culminated to a fruitful conclusion. Most professionals will agree that tying up an exclusive clearly indicates that half of the fee has been earned. Without this last step, the parties involved in securing the fee are working under more challenging conditions as other non-exclusive brokers may also be competing for the transaction.

PLACEMENT

Upon securing Control, Placement completes the process of successfully marrying capital with a project. Placement subcomponents include Underwriting, Marketing and last but not least, Closing — all discussed as follows:

Underwriting (20% of Total Fee):  As part of securing control and processing the transaction, underwriting bridges the gap between securing and funding the transaction. The key ingredients for underwriting — which accounts for 20% of the fee — include analysis, review of various documents and preparing a complete and detailed offering memorandum for sale, refinancing or other realty capital structure. Each of these components is described as follows:

• Document Reviews: Review of documentation involves reading and understanding key variables in a specific real estate capital transaction including leases, rent rolls, historical performance, physical property information and overall market dynamics such as supply and demand, vacancy, comparable property performance. 
• Financial Analysis:  Simple ratio tests, discounted cash flow analysis and other capital budgeting techniques are used for translating documents into financial ratios for further discussion.
• Offering Memorandum: The last component of underwriting is tying together all of the salient facts of the transaction including document highlights, location and property dynamics, financial analysis and sponsorship information 

Marketing (20% of Total Fee):  Marketing is the third component in sequential order, also representing a weighted average of 20% of the total fee. After the project has been secured for Placement and the information has been processed into a detailed offering memorandum, the marketing process begins. The goal of the marketing process is to deliver the optimal capital placement source for the project based upon contacting qualified capital sources, negotiating and filtering offers and conducting tours.

• Contacting Prospects: Contacting prospects is an ongoing process as the marketing team needs to identify the appropriate real estate capital sources including buyers, lenders and joint venture partners. The process is more extensive than simply cold calling as these prospects must be prescreened as to performance and reliability. More often than not, prospect relationships span a number of years and transactions. Furthermore, contacting prospects may also be challenging depending upon market conditions (prosperous economy vs. recession) and property types such as senior living deals and more complex mixed-use developments, for instance.
• Negotiating Offers:  The second step of the marketing process, negotiating offers, is equally as critical as finding the qualified prospects. Market knowledge and negotiating expertise always play key roles in determining the direction and scope.
• Tours and Inspections:  Finally, property tours in various other inspections can mean the difference between success and failure. Overall knowledge of the property, locational dynamics, immediate area, ingress and egress issues as well as overall market conditions, all lead to successful property tours.

Closing (10% of Total Fee):  Without a doubt, the closing must be handled with the same amount of importance as all other elements of the fee placement process. Too many things can go wrong if all parties assume that the transaction is on track by simply passing the closing process to the attorneys, title company and others. However, the transaction team should not provide legal advice unless properly staffed and authorized by the client to do so.  Instead, the responsibility lies in following through on any paperwork flow relating to the key business terms of the transaction based on the following:

• Document Review:  As to the business points of the transaction, the documents should be reviewed with the client to be sure that the negotiated items are identified.  Once again, any legal, tax, title or other technical document review issues should be left with experts such as accounts, lawyers and other third-party vendors.

• Processing Documents:   Processing the documents includes communications with attorneys, surveyors, municipal officials and other parties involved in documenting the transaction.  However, to the extent that documents need to be collected and assembled for further processing and review, the transaction team’s role will be defined as necessary, depending upon expertise and circumstances.

OBSERVATIONS

A host of other factors need to be considered when discussing fee sharing arrangements among real estate professionals including teamwork, sliding scales and  of course, qualifications.

Teamwork:  In today’s marketplace, most success real estate capital placements involve integrated teamwork, often in the same office.  In addition, highly specialized disciplines such as hotel consultants and healthcare professionals are involved in packaging and marketing special-purpose assets.  Even more expertise is required when working with single-purpose financing sources such as FHA/HUD and when equipment leasing is included with the property.

Sliding Scales:  Upon completing an initial transaction, various parties may decide to change roles and become more, or less involved. Subsequent transactions involving the same client may have lower fees splits with parties that have already initiated a transaction, but only want to share in the referral process. Other parties would therefore have more responsibilities, and take larger percentages of the fees.

Qualifications:  The skill set and experience are tantamount variables for sizing fee splits.

PROS AND CONS 

The advantages of using the Chicago Fee Distribution Model are as follows:

• Established baseline formula as a tool for further discussions.
• Systematic weighted-average point system providing benchmarks for measuring variables involved in determining equitable fee sharing arrangements.
• “Fine tuning” of key variables present indices for further discussion and weighted averages may be altered depending upon specific circumstances.
• Weighted average is for each variable helps define importance of various levels of resources, including labor allocation.
• Objective and independent methodology available to supplement existing fee arrangement policies within an organization.

Limitations include:

• Very difficult to address and weight intangibles such as professional experience, corporate loyalty, and other factors not included in the model.
• Variable and weighted-averages are subject to wide variety of interpretations.
• Weighted-average points are applied subjectively.
• Not all variables may be included.

Measurements are only as good as inputs.

EXAMPLES

Traditional 50/50 Arrangement: The classical example of a fee sharing arrangement assumes two parties, the listing agent and the buyer’s representative, share fees on a 50/50 basis. In this example, the listing agent has Control and the buyer’s agent executes the Placement. Fee Placement modeling is hardly needed as the roles are clearly defined.

Intra-office Arrangement: Medium and larger real estate organizations offering full services such as appraisal, consulting, brokerage and management normally have fee sharing policies. Even so, disputes surface various professionals view their roles differently in fee sharing. For instance, an appraiser who has a long-standing relationship with a property owner can get control of an exclusive listing and performs a substantial amount of investment analysis. Under such a scenario the appraiser would most likely not have a broker’s license, as well as play a very limited role in marketing and processing the closing. 

These circumstances justify a fee split of as much as 40% of the total fee calculated as follows:

• Control 20% – composed of 10% referral and generating lead plus 10% handling client communications and no credit for procuring exclusive as the 30% should be paid to the broker with the license responsible for securing listing and communicating with potential buyers.
• Placement 20% – full credit for underwriting including document review, financial and packaging. Again, the remaining 30% of the total fees relating to marketing and closing are not included in the appraiser’s list of responsibilities.

Structured Transaction Arrangement:  The more difficult and technical the realty capital placement assignment, the more scrutiny is required to determine equitable fee sharing arrangements. In the case of highly structured transactions such as joint ventures, land sale leasebacks, mezzanine loans, preferred equity deals and other hybrid debt/equity vehicles, multiple disciplines merge to complete the transaction.

The most common arrangement may include a combination of fee splits along with payments to outside vendors.   These outside vendors — including lawyers, accounting firms and financial consultants – will handle highly technical details relating to the marketing and structuring efforts of such transactions.  Fee sharing arrangements will often include flat-fee, hourly billing or other non-commission type payments.

In summary, structured-transaction fee sharing arrangements are difficult to illustrate.  Yet more often than not, highly sophisticated property owners work with equally sophisticated capital funding sources, demanding highly-professional, multi-level services.

CONCLUSIONS

The Real Estate Capital Placement Fee Split Model presents a clear and concise that of discussing the sharing of fees and distribution of responsibilities. In and of itself, this process is not a substitute for clear communications between all parties, a rather a guideline of how fees should be shared along with responsibilities.

The most important element within this process is open and honest dialogue. Also, should circumstances change, including allocation of time and resources, all parties need to be flexible on fee sharing modifications.

Prepayment penalties can be a substantial latent cost for borrowers, as well as attractive profit protection for lenders.  Borrowers require flexibility, while lenders seek yield preservation.   

Prepayment language is more important today, as the yield curve favors long-term debt with better pricing and terms than shorter maturities.  All things being equal other than term, the major difference between notes rests within the prepayment calculations. 

Nearly all short-term loans of five years or less have liberal prepayment penalties, and in some cases, none.  Long-term debt is often burdened by the prepayment penalties that can cost as much as 10% of the loan balance, depending on the formula used.

Some overall rules about prepayment penalties are as follows:

1)         Usually locked out from prepayment during first half of the term

2)         Negotiable if coupon rate is substantially below current market rate

3)         Minimum penalty typically at one percent

4)         Yield-maintenance formula works best for borrowers expecting lower rates later in the term

5)         Declining Balance formula provides calculated certainty in loan payoffs

6)         Defeasance formula requires costly processing and multiple approvals – more applicable for locked cash flow loans (e.g., long-term, net lease properties)

7)         Types of funding sources have a direct correlation on prepayment formulas (e.g., balance sheet lender has more flexibility than lender intending to sell the note)

Chicago, Illinois, November 20, 2008 – In today’s extremely difficult funding environment, financing even the most straightforward types of commercial real estate projects proves to be tricky.  In fact, commercial mortgage originations are nearly at a stand-still as lenders attempt to sort out financing dynamics in such an uncertain funding environment.

Of all realty asset classes seeking financing, land loans are the most difficult to entertain.  Any mention of land loans is the equivalent of discussing financial toxic waste.  The current lending and regulatory environment demands any real estate collateral by secured with proven cash flow and limited leverage – neither work well with land loans.  Under such conditions, land loans are limited to high-risk funding sources demanding extremely pricing premiums. 

The highest rewards (and risk) are available in the land acquisition and development arena.  For the most part, land is burdened with carry costs and seldom has any income.  Future use, including economic feasibility and zoning are yet to be identified.  Also, land is immediately impacted by economic cycles.

Land development and entitlement are exclusively focused on the preparation of site preparation for further development.  Locational, physical, legal, and financial elements are interwoven including typography, environmental standards, change of use (zoning) and community concerns.

Most successful land development models are based on “wholesale” land acquisitions (unentitled, raw land) and “retail” dispositions to users, developers and investors. 

Typical formula or land development is based on purchasing an option for the land, the most profitable method.  The option money is used to explore various zoning and physical issues with the site.  Should the process successful, the developer can then use the remaining part of the option to purchase the land.  Alternatively, if the option is not available because of the land value, a developer needs to prequalify much of the main risk issues including zoning, entitlement, demographic: analysis and physical features such as environmental issues.

Under all of these scenarios, local presence in the market is crucial for success.  Some land deals may take three to five years before any results are shown.  Hence, many national firms use local development expertise to assemble and entitlement.

 Unanticipated problems (e.g., extremely costly environmental cleanup), unrecoverable expenses, cost overruns, illiquidity, lost time,  and damaged relationships with governmental local authorities/community groups are among the numerous issues influencing development yield profiles.  As a result, land development ventures often require overall returns of 25% or more.  Even at such yields, changing market conditions such as the current credit crunch and supply-and-demand dynamics make for highly elusive profits.

 While land investing is extremely challenging, financing is still available even in today’s restrictive lending environment.  In order of importance, current funding parameters are as follows: 

1. Prime sponsorship required with proven track record strong financial statement well in substantially in excess of land value.
2. Full Recourse required and additional collateral often necessary, including projects with current cash flow stream.
3. Well below fifty percent or less of value based on recent valuations adjusted for currently depressed market conditions [e.g., 50% to 80% discount typical based on values of peak market cycle 2005-2007].  Lend in infill locations strongly preferred.
4. Pricing reflects significant premiums as compared to any other real estate asset class.  Terms are similar to other business-lending parameters such as line-of-credit fundings.

According to the Real Estate Capital Institute’s Research Director, Nat Zvislo, “Land and development loans present the most challenging fundings.  However if conservatively underwritten, lenders see such loans as excellent opportunities for maintaining and building new client relationships during such difficult times.”

ABOUT US:

The Real Estate Capital Institute is a research organization staffed by industry volunteers who collect and track debt/equity rate data.  The Institute’s website provides daily and historical rates including treasuries and short-term rates.  The Real Estate Capital RateLine (773-227-4825) announces hourly rate updates throughout each business day.

Chicago, Illinois, November 12, 2008 – The old cliché – “Cash Is King” is as true now as ever given the sparse availability of leverage.  Nearly all real estate financings, both acquisition and refinancing, are restricted to funding projects with existing, in-place cash flow.  Cash-flow projections, projects with value calculations based on appreciation (e.g., land) and other ventures lacking sufficient current income ventures are shunned.  Lending is severely restricted as the Real Estate Capital Institute® estimates over 80% of conventional funding sources are temporarily out of the market.

What should be expected when seeking financing today in such a constricted lending atmosphere?

• Cash Flow:  All in all, expect more conservative underwriting across the board when reviewing revenue streams.  In addition to underwriting actual cash flow, lenders are providing further safety nets by including conservative occupancy calculations (using the lower of actual or market vacancy), higher management fees to reflect more hands-on operations, larger operating reserves and richer expenses including escalating property taxes and utilities costs.

• Sponsorship:  More important then in any recent years, sponsorship financial net worth, experience and liquidity are tantamount. Even with nonrecourse loans, lenders need to be assured that borrowers have the ability to maintain projects running into operational difficulties.  Borrower net worth should approximate loan amount and liquidity levels of about 25% are typical.

• Loan Terms:  Lenders are competitive on rate, rather than leverage or other underwriting variables such as interest-only payments, property types or Earnout formulas. Only standard, income-producing properties such as apartments, shopping centers, office buildings and industrial properties are desirable as lenders have limited appetite for real estate debt in general.  Expect 65% loan-to-value for all properties except apartments, which can reach closer to 75%.  Overall rates are hovering in the 6% to 7.5%, including fixed and floating.

The bottom line?

As the markets remain constrained in the foreseeable future, lenders active in the market are extremely selective.  Borrowers must prove themselves creditworthy, both at the project and sponsorship levels.  As such, loan deliverability is the most important variable in today’s real estate capital environment.

Chicago, Illinois, October 22, 2008 — The start of the mortgage meltdown over a year ago continues wrecking havoc on the real estate capital markets.  In particular, accurate property valuation is nearly impossible as buyers and sellers are sidelined due to limited debt availability. 

Few properties are trading hands.  Most investors believe values are trending downward in response to economic malaise, oversupply and lack of affordable debt.  As such, experts are using higher cap rates for valuating assets for most types of commercial and income properties.  Lenders, in particular, are “creating” values by underwriting capitalization rates which may, or may not, reflect current market prices.  These cap rates are typically higher than many sellers are buyers expect, resulting in lower loan proceeds based on loan-to-value restrictions.  Yet, owners often refuse to sell or acknowledge asset values based on lenders’ higher cap rates, choosing to do nothing, instead.

In this stalemate, who’s right and where are cap rates heading? 

An amusing theory discussed by some experts as a humorous factoid suggests that current capitalization rates are directly correlated to the recent year numerical identity as indexed to the current real estate capital boom/bust cycle. Today’s market cycle peaked in 2007, with 2005 and 2006 ranking as the best years for very attractive valuations; in other words, low capitalization rates.

As for 2008, an 8% capitalization rate is the “strike price” for sellers motivated to liquidate properties.  While the markets are illiquid and few transactions leave any proof of value, an 8% capitalization rate reflects a weighted-average premium tied to the cost of capital for most types of income properties.  Applying the same logic in a downward market, 2009 should yield a 9% rate and a 10% cap rate would prevail in 2010.

Linking cap rates to year numerology is certainly an unrealistic discussion for measuring values in the currently volatile market.  Yet as investors search for answers in such uncertain times, numerology adds more theories to an already confusing time.

Prepayment penalties can be substantial to borrowers, as well as attractive profit protection for lenders.  Borrowers need flexibility, while lenders seek yield preservation.   

Prepayment language is more important today, as the yield curve favors long-term debt with better pricing and terms than shorter maturities.  All being equal other than term, the major difference between notes rests within the prepayment calculations. 

Nearly all short-term loans of five years or less have liberal prepayment penalties, and occasionally, none.  Long-term debt is often burdened by the prepayment penalties that can cost as much as 10% or more of the loan balance, depending on the formula used.

Some overall rules about prepayment penalties are as follows:

1)         Usually locked out from prepayment during first half of the term

2)         Negotiable if coupon rate is substantially below current market rate

3)         Minimum penalty typically at one percent

4)         Yield-maintenance formula works best for borrowers expecting lower rates later in the term

5)         Declining Balance formula provides calculated certainty in loan payoffs

6)         Defeasance formula requires costly processing and multiple approvals – more applicable for locked cash flow loans (e.g., long-term, net lease properties)

7)         Types of funding sources have a direct correlation on prepayment formulas (e.g., balance sheet lender has more flexibility than lender intending to sell the note) 

Nat Zvislo, Research Director of the Real Estate Capital Institute® states “Prepayment penalties should closely match the borrower’s holding term and operating objectives.”   Adding, “The premium negotiated is often the difference between a ‘good’ loan and a ‘great’ loan.”

Chicago, Illinois, November 8, 2007 – The highest risks and rewards are clearly centered in the land acquisition and development arena.    Land is the first development ingredient impacted by economic cycles as is painfully obvious in today’s residential markets.  And even in good times, land is burdened with costs and seldom offers income.

And while land development is in the doldrums, should developers abandon this sector for now?  And if not, are the capital markets even interested in funding land development? 

Developers with strong local market expertise should not give up on the market as long as costs can be controlled over a prolonged timeline.  As such, local presence is crucial for success because:

• Land deals may take three or longer before any results are shown.  For example, many experts predict the current residential markets will not fully recover until 2010 or longer. 
• National firms don’t have the expertise and community relationship skills of local players.
• Communities often mistrust “outsiders,” translating to longer entitlement processes and higher risk of failure.
• Satellite-office operating costs often don’t justify local market presence for all but the largest projects.
• Goodwill – Communities recommend and approve new opportunities in the area.
• Making a difference – the satisfaction of improving a community and offering better standards for its residents.

Capital market sources are also more comfortable with “on the ground” experienced land players, as their developments are focused within a specific area.  Funds are available, but on a selective basis.  Today’s funding parameters are as follows:

• Overall yields of 25% or more. 
• Fifty percent or less of value.
• Floating-rate, pricing of 175 basis points or more over LIBOR (often much higher pricing).
• Recourse financing typically required, unless more equity is available.
• Financial net worth should, at a minimum, be greater than land value.

According to the Real Estate Capital Institute’s research director, Nat Zvislo, “Land development ventures will be one of the best investment opportunities available, particularly broken deals that can be completed by seasoned players with solid financial backing.”

Chicago, Illinois, September 26, 2007 – Given this late summer’s tumultuous realty capital markets and property oversupply concerns (e.g., retail and residential), borrowers are often puzzled about how new construction loans are underwritten. 

Conventional wisdom dictates the most important factors for underwriting and funding a construction loan include the basics: equity, borrower financial status, location and project costs/physical characteristics and projected economics.   While these variables are fundamental for underwriting a loan, questions remain as to the specific details for approving a loan at the “correct” level.  

Not every lender has a “secret black box” for sizing loans.  However, some clear underwriting trends are emerging, including the following:

1. Completion guarantees are supplemented with full recourse, even after project completion.
2. Where applicable, more stringent preleasing requirements to generate at least breakeven cash flow on debt service.
3. 120% or more debt service coverage ratios applied on “stress test” mortgage constants (within the 7.5% or more range) which replacing capitalization rate valuations for calculating leverage underwriting restrictions – generally translating to loans of 75% or less of appraised value based on stabilized cash flow analysis.
4. Extremely wide pricing variations with a range of 150 basis points or more over the floating-rate index — typically LIBOR.
5. More costs as a minimum fees are increased (typically 1%) and other incentives reduced,  or removed, such as discounted legal and third party processing fees.
6. Existing clients receive greater preferential treatment as lenders are more selective and cautious regarding new client relationships.
7. Given this month’s LIBOR volatility, other indexes are negotiated (e.g., Prime, treasuries.)
8. Exotic financing vehicles such as mezzanine, preferred equity and other high-leverage are shunned.  Projects need to have “clear and simple” equity.

The research director of the Real Estate Capital Institute, Nat Zvislo says “Construction loans are summarized as more, more, more…More preleasing, more equity, more yields, more fees and more guarantees.”  Adding, “All factors equate to less risk.”

Chicago, Illinois, September 19, 2007 — Since December, the yield curve remains inverted, suggesting the looming threat of a recession and credit market turmoil.  However, the previous time the yield curve inverted within the past decade, a recession did not occur.   This phenomenon has proven to be a result of domestic and international investors flocking to longer-term, US debt instruments.  The winners, of course, are long-term borrowers.  Here is why:

1). Abundant supply funds and lenders (although pricing is readjusted to closer reflect risks in subprime debt)

2). Amortization schedules flexible, including interest-only

3). Best spreads and lowest rates as compared with other shorter terms

4). Ideal for fixed-income, cash flow (e.g., single tenant, credit lease)

5). Nearly all types of income-properties with provable cash flow are suitable

6). Long-term protection against inflation and rate increases, as rates are locked

7). Property will be worth more with below-market debt, should interest rates increase

8). Closing costs and bundled third-party fees are competitively priced and spread out over a longer term

9). Flexible loan payoff provisions are negotiable at an additional charge

10). Various leverage levels provide additional discounts and pricing options

The main risks of locking into long-term debt include: short-term hold/sell strategy, interest rate declines create lower asset values, limited flexibility for additional loan proceeds and restrictive prepayment provisions.

The Real Estate Capital Institute’s research director, Nat Zvislo, says “ten-year-term loans are often priced 15 to 20 basis points lower than shorter-term debt of five to seven years as mortgage buyers prefer longer-term notes.”

Chicago, Illinois, September 15, 2007 — During the “credit crunch” of the past two months, most of the focus remains on loan performance and treasury rates.  While these indices are accurate gauges of market conditions, a long-ignored index resurfaced on the watchlist — LIBOR ( London interbank offering rate).

While treasuries and other domestic rates continued declining, LIBOR climbed more than 50 basis points during this time.   Caught off-guard, realty borrowers quickly discovered this index moved in the opposite direction of Treasuries.  LIBOR increased based on a variety of factors, including:

• International Bank Uncertainty: This index is the international bank pricing benchmark.  Many European banks, for example, one US mortgage subprime debt.  These banks are concerned about credit quality erosion and are protecting their portfolios, requiring higher risk premiums to reflect more uncertainty within the marketplace.
• Strong Demand: The high demand for floating-rate debt within uncertain market conditions allows institutions to capture larger rate premiums.

LIBOR’s re-pricing forces borrowers to move from the floating-rate sidelines and reevaluate their capital needs/pricing using the following four guidelines:

1. Optimum Index: If floating rate debt is needed regardless, immediately review other indices including Prime and other government/bank indices.  Should request the option to change indices during loan term. 
2. Longer-Term Hold: A holding strategy will be more permanent (e.g. five years or more), redirecting financing towards fixed rate pricing.  Fixed-rate pricing is over 25 basis points  more price competitive than floating-rate debt given market conditions of mid-September.
3. Debt Value Enhancement: Belief in rising rates prompts the decision to capture permanent debt as such funding would likely enhance property values with “below-market” debt at a future date.
4. Project Dynamics: Floating-rate debt is required for repositioning selling assets.  If the timeframe is relatively short, borrower should look into purchasing interest rate hedges.   

According to John Oharenko, advisory board member of the Real Estate Capital Institute®, “Floating-rate debt based on LIBOR should be re-examined as a pricing index.”  He adds, “However, a financing decision should not solely drive property holding strategies, especially if sale or redevelopment is looming.”