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! The!implementation!of!Basle!III!is!changing!the!way!real!estate!lenders!are! structuring!construction!loans.!“The!Basle!III!regulations!have!increased!the!risk! based!capital!charges!associated!with!bank!financing!of!development!deals!which! can!be!categorized!as![high!volatility!commercial!real!estate].!The!composition!of! the!capital!stack!and!the!amount!of!borrower!cash!equity!in!development!deal!is! receiving!more!scrutiny!from!the!senior!lenders,”!said!James!Henderson,!CIO!of! Cornerstone!Real!Estate!Advisors’s!alternative!investments!group.!
! “We!have!observed!a!number!of!banks!interpreting!the!regulations!in!manner!that!is! shifting!them!away!from!mezzanine!financing!in!the!stack,!now!requiring!it!to!be! structured!as!preferred!equity.”!
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Mezzanine!debt!has!traditionally!been!preferred!by!lenders!given!the!more! favorable!foreclosure!rights!under!the!Uniform!Credit!Code!in!situations!where! there!is!a!default.!Many!of!the!structured!finance!shops!that!have!historically!

deployed!mezzanine!are!trying!to!incorporate!many!features!of!the!traditional! mezzanine!structure!into!preferred!equity,!Henderson!said,!explaining!that!this!is! tending!to!decrease!the!amount!of!first!mortgage!money!in!the!capital! stack.!“The!way!the!regulations!are!being!interpreted!and!implemented!by!senior! lenders!is!all!over!the!map,”!he!said.!!
! Banks!are!responding!in!varying!degrees!to!one!of!the!lesserOnoted!components!of! Basel!III,!which!provides!a!framework!for!soOcalled!HVCRE!such!as!construction! loans.!The!guidelines!were!instituted!in!January!and!the!effects!are!absolutely!being! born!out!in!the!market!place,!said!Douglas!Heitner,!a!partner!in!the!real!estate!group! at!New!York!law!firm!Kasowitz!Benson!Torres!&!Friedman.!“[The!borrowers]!are! not!saying!‘We!want!preferred!not!mezzanine,’!this!is!being!driven!by!the!senior! lenders!who!are!saying,!‘I!can’t!have!mezzanine!behind!me,”!he!added.!!
! Preferred!equity!providers!are!asking!the!exact!same!control!rights!as!the!mortgage! and!mezzanine!lenders!are!receiving,!in!the!form!of!operating!covenants!that! encompass!no!additional!debt,!no!liens,!transfer!restrictions!and!construction! administration,!according!to!Heitner.!“We!have!seen!many!preferred!equity! providers!ask!for!the!right!to!buy!the!sponsor’s!equity!for!$1,!which!is!an!effort!to! replicate!mezzanine!foreclosure,”!he!added.!!
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One!unresolved!question!is!related!to!a!15%!equity!requirement!from!the!borrower,!
another!newly!implemented!component!of!Basle!III.!In!the!past,!a!portion!of!the!
15%!equity!requirement!could!be!filled!by!appreciated!land.!“But!now!banks!are!
interpreting!the!new!regulations!to!require!land!to!be!contributed!at!cost,!which!in! many!cases!puts!a!developer!in!a!position!where!there’s!a!need!for!dollars!in!the! capital!stack!that!wasn’t!there!previously,”!Henderson!said.!Furthermore,!the!15%! equity!in!the!deal!as!measured!against!the!value!of!the!property!upon!completion! compounds!the!need!for!alternative!capital!sources.!The!question!of!if!subordinate! debt!can!be!included!in!this!15%!equity!requirement!appears!to!be!open!to! interpretation!by!the!banks,!he!added.!!
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This!shift!has!also!led!more!nonOtraditional!lenders!to!fill!in!the!gap!in!situations! that!are!too!risky!or!complex!for!banks.!“With!the!increase!in!the!number!of!debt! platforms,!we!are!seeing!fierce!competitions!that!resulted!in!borrowerOfavorable! conditions,”!said!Ari!Hirt,!a!managing!director!in!the!debt!and!equity!finance!group! at!Mission!Capital!Advisors.!The!firm!has!see!situations!with!leverage!of!up!to!90%! and!floatingOrate!pricing!as!low!as!1%,!he!added.!
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Mission!arranged!one!of!the!more!complex!structures!to!date!when!it!advised!on!a! rare!deal!that!carries!multiple!layers!of!subordinated!debt.!The!firm!represented! sponsors!Property!Markets!Group,!Kamran!Hakim!and!New!Valley!on!the!2014!deal,! backed!by!the!Queens!Plaza!South!in!Long!Island!City,!and!arranged!$148.45m!in! nonOrecourse!financing!for!the!development!of!the!44Ostory,!391Oapartment!rental! tower!at!23O10!Queens!Plaza!South.!
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“The!biggest!challenge!in!structuring!a!deal!with!multiple!layers!of!subordinated! debt!is!ensuring!that!each!capital!provider!has!adequate!rights!and!remedies,”!said! Hirt.!Deutsche!Bank!provided!the!construction!financing,!which!represented!70%!of! the!total!capitalization,!and!NorthStar!Realty!Finance,!the!first!mortgage!land!lender,! provided!a!$40.25m!mezzanine!loan.!The!total!financing!was!$188.7m,!or!about!
90%!of!the!total!project!capitalization.!
! While!the!leverage!was!high,!there!are!several!mitigating!factors,!Hirt!said.!The! sponsors!are!extremely!experienced!and!were!able!to!buy!the!land!for!less!than!
$200!per!square!foot.!The!deal!was!also!far!enough!along!in!the!development!
stage!to!reduce!some!of!the!associated!risks!with!construction,!he!added.!
! But!despite!nonOtraditional!lenders’!willingness!to!tackle!a!variety!of!debt!and! equity!combinations,!banks!still!dominate!commercial!originations.!Indeed,!banks! accounted!for!37%!of!the!total!volume!in!2014,!and!in!2015,!despite!the!dip,!the!
29%!of!nonOagency!commercial!lending!surpassed!that!of!conduits,!life!companies!
and!other!lenders,!which!each!captured!20%!and!26%!of!the!market,!according!to!a!
report!published!by!CBRE!Capital!Markets.!
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“Some!of!the!healthy!banks!are!willing!to!withstand!the!150%!capital!charge! associated!with!HVCRE!if!they!are!achieving!attractive!margins!on!a!particular!deal,! but!most!banks!appear!to!avoid!this.!The!net!effect!seems!to!be!an!increase!in! demand!for!subordinate!debt!and!a!shift!towards!structuring!what!previously!was! mezzanine!as!preferred!equity!even!though!they!occupy!the!same!spot!within!the! capital!stack!and!have!generally!similar!economics,”!said!Henderson.!“But!this!does! not!mean!the!market!is!frothy!or!overly!creative.!For!the!most!part!there’s!a! reasonable!amount!of!discipline!in!the!migration!from!mezzanine!to!preferred.! Should!a!provider!of!preferred!be!compensated!more!than!mezzanine!
–!yes,!slightly,!but!whether!the!market!bears!that!out!remains!to!be!seen,”!he!
concluded.!!
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