Commercial Loans and Programmatic Equity
Value-add commercial real estate investments typically target properties that have in-place cash flow, but they seek to increase that cash flow over time by making improvements to, or repositioning, the property. In other words, the property has tenants, but they are paying substantially below the potential rent that the property could be getting. In a value-add investment deal, the transaction’s sponsor makes an active effort to elevate the income stream of the property, typically through a significant capital improvement program, such as a partial or property-wide renovation. Examples of such improvements might include new paint, new signage, renovating the lobby, and improving the security of the property and the parking area, etc.In their marketing flyer, JCR Capital advertised preferred equity, joint venture equity, and programmatic equity. Programmatic equity? What the heck is programmatic equity?Before we get into programmatic equity, lets first do a quick review of the term, "equity". Equity is not just the difference between what your house is worth and the balance on your first mortgage.Equity - in the context of real estate - is the money that the owner stands to lose before "the bank" loses its first penny. Obviously, "the bank" could also mean a credit union, a life company, a conduit, or any other type of real estate lender. Equity is often referred to as the first-loss piece. If anyone is going to lose any money on a real estate deal, the first guy to lose a chunk out of his tush is the equity holder (the owner).Example:ABC Development Company specializes in turning around big apartment projects that have become run down. In downtown Washington, DC, ABC Development learns of a 360-unit apartment project within two miles of Capital Hill. The well-located apartment project was once filled with ambitious, young political staffers; but when the old man died, and his wife took over the management, the condition of the property and the rents plummeted.ABC Development can acquire the property for just $32 million, but the renovation costs are another $9 million. With an interest reserve and the other necessary soft costs, the total project cost is $46 million. The bank, with whom ABC Development has a relationship, will only loan up to 70% of the total cost because the project has become a big drug house and a gang hang-out. A huge renovation project like this needs to be structured like a construction loan. Who remembers the four elements of Total Cost? Of course, there is the land cost (in this case, the cost of the land and the building), and then there are the hard costs (bricks and mortar). What else? Soft Costs - that's right! Good job.But you are still forgetting the fourth element of Total Cost (of a development project). It's the contingency reserve. A good rule of thumb when computing the contingency reserve is to use 5% of hard costs and soft costs. Why not 5% of the land cost? Because by then the developer already knows the cost of the land. There is NOT going to be a cost overrun in connection with the land.Therefore the total cost of a development project is the land cost, plus the hard costs, plus the soft costs (interest reserve, architectural fees, engineering fees, points, closing costs, etc.), plus the contingency reserve.Okay, now let's get back to ABC Development's big value-add deal. We said the total cost was $46 million, and the bank was willing to lend $32.2 million - which is 70% of the total cost. Therefore ABC Development will need to contribute $13.8 million. The development company has $3.8 million to contribute, so it will need an equity provider willing to put up the remaining $10 million.