Why Debt Funds Should Get a Look for Office Makeovers

Charlie Kokernak

As we look at the year ahead, one of the most compelling challenges and greatest opportunities emerging in commercial real estate post-COVID will be reestablishing the relevancy of the office sector. The dramatic impacts from the shift to remote work during the pandemic continue to disrupt the operating patterns of office buildings across the United States. From primary MSAs to suburban submarkets, office space will need to adapt to meet the future needs of working professionals and occupiers in the decade ahead.

What are those needs? Current forces are changing the focus on how we use office and how we engage with it. For many businesses, the gaps in collaboration and mentorship are straining legacy development. Employees, however, will need to be convinced that there is value in returning to the office. What will be the draw to get them back? Higher-quality space? Amenitized environments that engage users? Or, is it reprogrammed floorplans that embrace flexibility? It might be all the above.

In order to adaptively reposition our existing properties, older spaces will need to be renovated to both draw new office tenants and retain current users. Improvements and pivots are not without additional investment. The good news, however, is that, given the historically low cost of borrowing, one of the best ways to successfully fund these upgrades is though bridge financing. 

Traditional lenders are struggling to underwrite in this climate as they are cautious by nature. They are comfortable lending against 60 percent to 75 percent of the value of a functioning real estate asset, but, when creative repositioning is considered, they typically prefer lower leverage offerings as they infrequently participate in the upside potential of a property. That said, there are alternative sources for the funding necessary to complete these adaptive projects.

Private debt funds have emerged as an attractive source for financing the future of office in the current market cycle as an alternative to traditional bridge loans offered from banks, which require a personal guarantee. These lenders are becoming an active force as their funding power grows. This rise in available capital is the result of investors seeking return in a low-yield environment. These investors see debt fund investment as a way to hedge against inflation.

The Many Faces of Debt Funds

Unlike traditional lenders, debt funds are often willing to fund up to 80 percent loan-to-cost for a project, leveraging their access to a lower cost of capital to climb higher up in the stack. While they do charge a little more than conventional lenders, many times their single source of capital is lower than the blended rate that would be derived from the combination of a conventional lender and new equity investment. Additionally, a debt fund’s interest-only and non-recourse structure provides appealing terms that are frequently lower than the debt constant of an amortizing loan, allowing any available cash flow to make its way back into the project.

While bridge capital does come with a risk premium, the goal is to effectively reposition a property to become a front leader in the return to office and enable it to attain traditional financing at 60 percent to 75 percent of its as-stabilized value upon completion.

Debt funds can take many forms. The first is a “family office” arrangement—typically a group of private individuals seeking yield on their money by pooling cash within an investment fund. Contributions come from accredited investors who may be seeking to diversify their portfolio along with direct investment in real estate, bonds and equity market opportunities. Another debt fund model involves a similarly sophisticated investment group, but in this scenario, capital comes from a warehouse line arranged from a larger banking partner. Funds are deployed with the right to securitize the debt payments into a bond offering known as a collateralized loan obligation. Lastly, the most recent form of a debt fund can be seen with the crowdfunding model, wherein individuals invest via an online portal into one or a number of mortgage loans, distributing their risk with a wide pool of co-investors.

Finding the right financing partner for a project requires research as to a lender’s yearly allocation, regional focus and market comfort, which are all important factors. Regardless of the exact lender who partners with an owner intending to revitalize an asset, the goal is straightforward: position property today to be best equipped for the world of tomorrow.

Charlie Kokernak is a director with Gantry.