REQUIRED READING: Asset-Based Financing: Procedures And Case Studies

Written by James Essa & Karna Hoskote
on March 13, 2009 No Comments
Categories : Required Reading

Traditional financing provides much-needed funding to advance major commercial real estate development or other tangible projects and can be particularly beneficial to companies that plan months in advance.

But what happens when funding is required immediately or when clients have minimal experience? In these cases, asset-based financing can often help clients avoid the complexities involved in traditional financing methods. Commercial finance gurus know the challenges of getting projects funded. Aside from conventional funding sources, such as banks, commercial mortgage-backed securities and life insurance companies, other ways to fund bigger or more complex projects are a must in order to add value and ensure that financing is secure.

As a commercial mortgage banker or broker, you have multiple roles. One of those roles is to act as an advisor to your clients. As an advisor, you should stress to borrowers both the benefits and pitfalls of financial instrument funding.

There are certain times when asset-based financing is a stronger, more viable alternative than traditional funding. A veteran developer that has worked on large projects knows the ropes. These developers understand how much paperwork is involved with borrowing money from a bank for a traditional loan, and how questionable the stability of their financing can be.

Chances are, they have been burned by lenders that walk them through the process of financing their project only to pull the rug out from under them at the closing table, leaving them scrambling to find new financing in a hurry so that their deal does not fall through. This process wastes precious time and money for the developer.

In addition, projects in international markets often present unique challenges that can be made more secure by using asset-based financing. A developer will not want to spend months or even years finding the right property to develop, getting the necessary permits and doing feasibility studies – and then see the funding entity change its mind.

Working on multiple projects, developing projects in international locations and tackling large projects are all viable reasons to pursue asset-based financing as an alternative option.

However, not all projects are right for asset-based financing. If the developer is leasing a financial instrument, no lender will lend against that leased instrument, because the lender cannot block it for an appropriate period of time. The financial instrument would be considered at risk, because paperwork for leased instruments can be easily forged, and therefore, it is considered unreliable.

Furthermore, some developers might shy away from asset-based financing if there is a traunching schedule associated with the loan. Developers may need large amounts of money quickly. Although circumstances requiring quick funding is rare, the developer may be working on multiple projects and need more flexibility.

Unless all the money is required up front, this arrangement typically does not interfere with the project itself. However, some developers might be uncomfortable with the terms.

Letter of credit
Because of strict guidelines, traditional lenders may be limited with regard to the types of large commercial projects they finance. In addition, the lending agreements often involve formal appraisals, third-party reports and approval from loan committees. In many cases, clients also need previous experience or equity partners to qualify.

Traditional commercial financing may also involve last-minute surprises should the bank or financial institution change terms or pull all of the funding. Even with adequate assets, the project may not garner approval. Additionally, a bank can call the notes due at any moment if its lending guidelines change or if its investors or regulators are dissatisfied with the lending institution's choice of investments.

These potential complications lead some clients to private capital providers. While useful in some situations, these funding sources might also introduce even more challenges, including higher rates, lower loan-to-values (LTVs), shorter terms, higher fees and more exposure to the failure of the project because of external or internal factors.

In situations that involve a commercial project or other tangible project, asset-based financing can provide a faster and more direct path to approval. Asset-based funding leverages the client's existing assets – in most cases, eliminating appraisals, third-party reports and loan committees.

Further, this option provides elevated client privacy. Asset-based financing does not require business experience or equity partnership, and approval may be granted in as few as three to five days, expediting funding in 30 to 60 days.

It is important to note that the financial instruments used in asset-based lending are backed by investment-rated banks. If the borrower defaults, the funding entities are protected.

To launch the process, a client requests a letter of credit (LOC) issued by an investment-rated bank. LOCs are bank-issued financial instruments guaranteeing payments for a specified duration, provided that the instrument's conditions are met. The LOC, also known as the standby letter of credit or irrevocable letter of credit, must be unconditional.

Clients must also have adequate support assets. Investment-rated banks issue these directly to the client, with rating requirements based on the type and amount of financing.

Many developers use asset-based financing to avoid the hassles involved in proving their project to a traditional finance company. Because asset-based financing is leveraged against existing collateral, this is all the support and leverage they need to close the deal.

With terms based on the amount and type of financing, clients might benefit from monthly compounded interest and payments to simple interest terms with deferred payments and no pre-payment penalties. Flexibility increases for LOCs greater than $100 million. Financial instruments are adaptable to meet the client's needs. For instance, many LOCs include an evergreen clause, which means the LOCs can be renewable and larger projects can be drawn out over time if needed because of external or internal factors.

The greatest benefit to the client is an increased LTV ratio, which can be significantly higher than those for traditional commercial financing, escalating to as much as 100% of the client's LOC face value. These higher LTVs can reduce the borrower's up-front cash requirements significantly.

Suitable clients
Asset-based financing is well suited for large business entities, developers, private equity funds principally in the real estate industry, or those primarily focused on tangible assets. Hedge funds are also strong candidates, minimizing project risk by using advanced investment strategies.

Asset-based financing can also provide a convenient funding environment for offshore development projects. With the added privacy provided by asset-based lending, developers can finance a diverse array of projects globally.

Following are two case studies in which asset-based financing was the appropriate choice for commercial real estate development.

Dreamland Development, a major resort developer, wanted to develop resorts in the Caribbean and faced several hurdles. The developer worked with several lending sources, but the process included a wait of 90 to 120 days to get expensive third-party reports, with no guarantee the project would be funded. Dreamland Development went through this process with several lenders and spent $250,000 on third-party reports. Ultimately, however, the company did not receive funding.

In summer 2006, Dreamland Development found a lender that specialized in asset-based lending. As an established firm with large assets and development experience, the company was able to get a financial instrument valued at $500 million. This deal was especially helpful given that the company planned multiple projects in various locations.

Because most projects that the firm worked on took around one to three years to complete, the company received a one-year LOC with a renewal option. The dealmakers chose a fixed rate over a variable rate – even though the fees were higher – in order to save money on the interest over a longer time period. The funding was completed in 30 days, and when the project took longer than expected, Dreamland Development renewed its LOC.

Asset-based financing can also be appropriate for multiple firms willing to consolidate assets for larger development. Midwest Development develops medium-sized apartments and condos, while Towers Development develops small to medium houses. M&T Development develops townhomes and mixed-use properties.

All three developers had experience in projects in the $20 million to $45 million range and wanted to work on much larger projects. They all ran into the same financing challenges: not having enough assets or experience and not wanting to deal with equity partners that would take a large portion of their projects.

Thus, the three developers combined their assets to form an entity called Global Development Corp. Next, they obtained an LOC for $120 million with a two-year term and an option to renew. They chose the fixed rate, as they were not comfortable with the variable payment method. Through this arrangement, they would pay once every year with simple – not compounded – interest.

Global Development Corp. was able to complete a 300-unit condo project in Florida costing approximately $110 million. The company was not required to find equity partners that would have taken a large portion of its profits, and it did not risk having its loan called due when the project took longer than anticipated to complete.

James Essa is president of Andorra Capital Inc., and Karana Hoskote is president of MBGM Capital Inc. Essa can be reached at jessa@andorracapitalinc.com, and Hoskote can be reached at khoskote@commercialfinances.net.

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