By James Nelson and Scott Singer
It has been decades since seller financing, previously known/structured as “purchase money mortgages”, have been widely used to facilitate and close sales. We expect that to change. There is much talk of the impact of rising Treasury/SOFR rates on cap rates and loan coupons. However, an equally important impact to address is the downward pressure on proceeds which results from debt service coverage ratio requirements. There will no doubt be a need to help bride the equity gap required for most buyers.
In one current instance, we are handling a sizeable, cash flowing multifamily portfolio. Even though the going in cap rate is around a 5%, debt service coverage ratio tests are constraining the leverage being offered by first mortgage lenders to only about 50% of the acquisition cost. While third party mezzanine loans are readily available at 65% or even 75% of cost on value-add transactions, in this case the portfolio is already well occupied and well managed and therefore not really a candidate for third party mezzanine financing.
This situation where a buyer needs to fund ~50% equity, greatly restricts the pool of buyers for many transactions and is a situation that is likely to occur on many stable property transactions in the current interest rate environment. We would like to suggest that new forms of seller financing (either mezzanine debt or preferred equity, as first mortgage
lenders no longer allow subordinate mortgage financing) may be an accretive solution for sellers looking to maximize sale prices while interest rates remain high and DSCR ratios therefore constrain senior mortgage sizing.
Many long-term owners who are looking to simply cash out as opposed to 1031 into a new asset, might benefit from deferring some of the purchase price and receiving a return on it. With moderate leverage senior mortgage coupons for many transactions in the high 5% range or higher, we expect that seller mezzanine financing at even 6%-7% would be
attractive to many buyers. This would not have been of interest to buyers over the last 10 years when senior mortgage debt was so plentiful and cheap, but times have changed.
Senior lenders will, of course, must be satisfied in a few ways – and seller financing should now be different than in prior periods. Second mortgages no longer exist, replaced first by mezzanine loans, then private equity, and now A/B lending structures. That issue is well-resolved at this point, but a larger, strategic question is whether senior lenders will treat
the full purchase price as market value in a transaction that includes seller financing. Many senior lenders are focus on the amount of “fresh,” or cash equity, being brought into the transaction.
We believe this valuation question would become a constraint in a situation where seller financing was covering the amount above the senior debt, but that is NOT what we are suggesting. Rather, we are postulating that sellers may fill the gap between the ~50% conventional acquisition debt that may be available in stable deals now, vs. the 65-75% range that would have been available a year ago. In that case, a buyer would still be investing 25-35% fresh cash into the deal, in a first-loss position with basis at the full purchase price, and we believe this creates a winning argument that the purchase price still does equal the current market value.
In this situation, the purchaser and lender are both happy. However, this a three-party negotiation – as such, it must also work from the seller’s perspective – bringing in questions of the likelihood of eventual full payment, tax sensitivities, and downside scenarios. In this case, we would argue that the seller’s downside could be considered an opportunistic
upside play. If the seller financing is structured as mezzanine, which many senior lenders will allow, non-payment would trigger a UCC foreclosure which can be a quick process; and if the cash payment at closing has been substantial (~25-35% cash paid to seller) and the new senior financing is low (~50%), a seller who needs to retake their asset in the future
is doing so with meaningful cash in their pocket and a very low debt load.
If there is one thing we are certain of after our combined 50+ years of deal-making, it is that nothing is simple in New York City commercial real estate transactions. What we have outlined distills very complicated matters down to a relatively simple construct, when there will be weeks to months of negotiations in a challenging market. But this is a roadmap to a new (old!) type of dealmaking that may soon be very much back in favor.