Scotsman Guide - February 2009 Commercial Edition

Finding Private-Equity Answers

Financing solutions could exist for clients who might otherwise pass on a good deal

By Craig Grella, co-founder, Cornerstone Funding Services Inc.

In today’s tight credit market, most conventional mortgage lenders — such as commercial banks and insurance companies — are falling back on time-tested, conservative underwriting methods. This includes requiring low loan-to-value ratios (LTVs); high borrower liquidity and net worth; and stable, low-vacancy assets. It’s likely harder for many of your clients to get high-leverage loans, and they’re often required to put up a larger cash outlay — receiving a lower return on investment.

Thus, many would-be property-buyers sit on the sidelines to wait out the market, and the volume of brokered deals is decreasing significantly. As a mortgage broker, however, you can help your clients move forward with their deals by helping them find private equity.

Your clients don’t have to pass on a good deal just because they’re short on liquidity. Many companies offer private equity for real estate transactions, and they operate much like private loan sources.

The major difference is that the money your client receives is not treated like a loan, and private-equity lenders do not take a subordinate-note position behind the first-lien lender. Rather, their money goes into the pot upfront with your client’s cash equity. In return, the equity firm receives a split of the cash flow and a split of the profits when your client sells the property.

Finding it

Finding private equity isn’t always difficult. In fact, most investors find their first level of private equity from family members, friends and close associates.

If your clients don’t have contacts with cash, you can help them dig deeper and get more creative. Make a list of local note-buyers, private lenders and others who have experience investing in commercial real estate and who understand the risks.

To win private-equity investors’ money, your client must first earn their trust. To do that, the client must demonstrate the merits of the investment while showing its potential to generate high returns. Your client can do this by highlighting certain property features, including:

■ How much equity is required;
■ The level of your client’s investment
compared to the needed investment;
■ The investment horizon or holding
timeline;
■ The property’s monthly or yearly cash
flow;

■ The exit strategy — will your client refinance the property in three years or sell it?; and

■ How much of the monthly cash flow
and profit from sale the investor will get
in return for the equity.

Determining the cost

There is no standard rate of return for private equity. Some investors will require a simple 10-percent to 15-percent annual return. Others will ask for a split of the cash flow commensurate with the ratio of their investment; a portion of your client’s exit cash flow; an overall yearly rate of return that could be greater than 20 percent; or a combination of these.

Private equity, like private loans, can be expensive. But if it helps your clients get the deal done while still making an acceptable rate of return, then you’ve achieved your goal and theirs.

Consider this example: If your client’s investment requires $100,000 of equity, but your client has only $10,000 in cash, then the additional $90,000 — or 90 percent of the total equity — is required. For that level of investment, some private-equity investors will require a rate of return of 90 percent of the monthly cash flow. Further,

when the property is sold, they may want an additional 15 percent on their investment.

Thus, if the property generates $2,000 in monthly cash flow, the investor would receive $1,800 per month. When your client sells the property, the investor would get the initial investment back, plus 15 percent, to equal $103,500. This leaves $200 per month for your client, or $2,400 per year, a 24-percent cash-on-cash return for every year your client holds the investment.

Other investors may take less upfront, but they may want higher returns on the back end. That would give your client more of the monthly cash flow and a higher return, but the back end benefits the investor — so much so that your client might not receive any money upon the property sale. In that case, your client is in it only for the cash flow.

Presenting the opportunity

Find your client’s rate of return by analyzing the property’s cash flow, adjusting for variables. Your clients use this to present to potential equity investors. Clients will highlight the investment’s profit-generat-ing potential and the equity investor’s potential profit.

Advise your clients to present the investment in the best light, including:

■ Giving investors an upfront overview in a few sentences so they know what to expect from the presentation. Does the project offer above-average returns? Can

they get special financing? Are they picking it up at a discount?

■ Putting the project in context from a macro level, geographically and conceptually. Present an area map and a site map upfront.

■ Having a complete financial analysis that shows all costs, value creation and the potential for the investor’s return on equity. Your clients should explain their exit strategy thoroughly and also address the risks and their plan for mitigating those risks.

■ Incorporating all team members; and
■ Leaving time for questions.

The better the presentation, the more likely your clients will receive the equity.

In addition, when your clients accept money, make sure they and the investors are acting lawfully. An attorney can advise them on securities regulations that may come into play.

■ ■ ■

Craig Grella, co-founder of Cornerstone Funding Services Inc. — a full-service real estate consultancy with offices in Long Island, N.Y., and Seattle — started his career as a civil and structural engineer. Working with developers made him aware of the challenges of commercial and development financing. As such, he transitioned from designing projects to financing them and worked as a senior loan officer with several national banks. Contact him at (800) 928-0845 or visit www.cornerstonesvs.com.

Many commercial property-buyers pass up deals for which they think they can’t immediately find financing. Doing so may cause them to miss potentially profitable deals. By helping clients find private-equity partners, you can help make sure they don’t make the same mistake.

As their broker, if you also can educate your clients and help them find private-equity sources, you can collect fees on the equity raised in addition to the fees associated with the bank loan.