The Last-Dollar Mindset

By Jay Maddox, Principal, Avison Young

There is a growing consensus among commercial real estate industry participants that we are reaching a peak in valuations. While most investors believe that we will continue to see stable market conditions at least for the next year, rent growth expectations are tempering. Despite the gradual decline in investor sentiment, the industry is flush with capital. In particular, private equity funds have tremendous liquidity, and they are under pressure to generate high returns for their investors.

Private Equity Funds Reducing Risk Tolerance

Increasingly concerned about the risk of investing equity at the peak of the current cycle, but continuing to seek high yields on value-added and development projects, many private equity funds have created debt platforms that offer high leverage “stretch” senior loans, mezzanine debt and preferred equity. By offering more proceeds and increased flexibility as compared to banks, they have been able to fill an important need in the marketplace while generating superior risk-adjusted returns.

However, the traditional business of joint venture equity where private equity investors take 80 to 95 percent of the equity as limited partners is becoming increasingly selective as the cycle appears to be peaking. More often than not, the reaction to a JV equity proposal in today’s market is, “It’s not the best fit for our equity group; however, we like the project and we’d be very interested in providing mezzanine debt or preferred equity up to 85 percent of the capital stack.” This mindset is often referred to as “the last dollar” or maximum risk exposure that the investor would be willing to accept. Needless to say, that spells higher equity requirements for developer/sponsors.

Risk-Return Tradeoff

The rationale behind this phenomenon is that private equity investors believe they can earn a superior risk-adjusted return by limiting their exposure to a lower level of the capital stack. The developer only has a small equity stake in the deal on a typical 90/10 JV equity structure with 60 percent debt financing—contributing only the last 4 percent of the required capital. If the project is fully priced, as is often the case at this point in the cycle, there is very little margin for error. On the other hand, providing mezzanine debt or preferred equity limits the investor’s risk (the so-called “last dollar”) to about 85 percent of the capital stack. The investor can still achieve a return of 12 to 14 percent with a 15 to 20 percent equity cushion ahead of him. This risk-return proposition is increasingly the norm, as private equity investors want to preserve their JV equity for only the largest, most compelling opportunities and the strongest sponsors.

Impact on Developers, Property Owners

This shift in investor preferences is causing heartburn for many middle-market developers, as well as property owners with maturing, over-leveraged CMBS loans who need more equity than they can typically source themselves. To make matters worse, many value-added and development projects are typically too small for institutional private equity funds to consider. Fortunately, while difficult to identify and access, there are capital providers who play in the $1 million to $10 million equity investment range where the need is the greatest. This segment of the capital market consists of a mixed bag of niche private equity funds, family offices, foreign investors, on-line funding platforms and high-net worth individuals. Developers and property owners facing such equity funding challenges may want to consider working with professional advisors who can help access capital in such situations, especially in cases where there is timing urgency.