The Art of Financial Engineering

Click here for the Original Article - Renat Yusufov

As institutional investors continue to populate real estate investment, the pricing landscape continues to get more competitive. As such, it is impossible to be an effective investor and meet expected returns without playing the leverage game. The opportunity to financially engineer varies by risk-profile, geography and asset class. Nevertheless, the range in leverage strategy still exists, as lenders continue to innovate with new products to participate in the industry.

The Risk:

When underwriting a real estate investment, the analyst can creatively “engineer” a certain return analysis through adjusting the debt or other business strategy adjustments. It is important to seek guidance from the relevant capital markets and operating advisers to identify realistic pricing and terms in the underwriting.

Furthermore, it is important to not get too aggressive on pricing and leverage points.

A Brief List of Engineering Options

I. Acquisition Debt:

As mentioned, debt is a necessary component of real estate investment and operation. The right lender can also serve as valued partner who can provide support and even open doors to investment opportunities and products. Debt engineering in your underwriting model can improve the project performance, and open doors to creatively structure a transaction that would otherwise not appeal to investors.

II. High Yield Leverage:

As mentioned, mezzanine debt and preferred equity can increase returns significantly. Nonetheless, the higher points of leverage and pricing increase the risk of achieving the target returns. Namely, mezzanine debt and preferred equity can serve as additional juice to hit the target returns, but increase the risk of missing the market on rent and exit prices. Usually, this risk is offset with capital reserves (to be used when income is insufficient to meet debt coverage).

III. Refinancing / “Good News” Proceeds:

“Good news” money is additional debt proceeds that the lender would make available once your property hits certain income targets. The lender is unable to provide these proceeds at closing due to the property not meeting certain risk requirements (i.e. coverage ratio or capped valuation). Good news money can serve as capital expenditures to provide the owner with money for tenant improvements and leasing commissions, as well as other property improvements. Additional proceeds in this format can come from the lender from the acquisition or from a new lender at refinancing.

IV. Hold Period Duration:

If your investment profitability is measured primarily with IRR, you are incentivized to receive cash flow sooner rather than later. Thus, shortening the duration of the hold period can severely increase your IRR. This is due to receiving the proceeds from selling sooner than initially expected.

V. Lot Bifurcation:

Similar to a shorter hold period, the underwriting can include a bifurcation of the lot, to sell partial development or ownership rights. This would allow for some cash flow to be returned sooner, without a full exit from the investment. This process can get tricky with receiving approval from the local community and lender(s).

VI. Income Growth Assumptions:

Depending on the market dynamics, it is possible to justify higher rent growth or a compressed cap rate at sale event(s). It is not uncommon to assume that some operating efficiency or property improvements can improve the income. Nevertheless, it is important to remain prudent to not misconstrue the project’s realistic potential.

Conclusion:

Responsible financial engineering can save a project that would otherwise be turned down, while not over-exposing yourself and your investors to financial risk. It is the “art” in the science of finance, and can play a key role in giving an investor an edge over competitors (even those with deeper pockets).

About the Author: Renat Yusufov