How Does Private Capital Price Risk?
We are all aware that there has been significant growth in the private debt market for funding real estate transactions.
While borrowers of private debt will focus on the funder's preparedness to stretch their offers of loan to value ratios and pre-sale to debt cover ratios, the issue that draws most attention from borrowers is the cost of the debt being offered.
What we will focus on in this article is the simple traps that borrowers fall into when having a lack of understanding of the fee structures on offer and then what the private debt funders are focused on in funding the transaction and pricing the risk.
Understanding the Fee Structure
There are numerous ways in which the private debt market prices its transactions but four key components comprise the overall cost of the debt:
The upfront fee, also known as an establishment fee, arranger fee or underwriter fee. As its name suggests, it is charged at the beginning of the transaction, normally at financial close when the funding is available to the borrower;
An administration fee, or loan management fee. Charged monthly in arrears this is a relatively small fee to compensate the lender for monitoring and administering the loan during the term, attending meetings including project control group discussions;
A line fee, also known as a commitment fee, charged on the full loan amount regardless of whether the loan has been partly drawn or fully drawn. This is the expensive part of the transaction – paying for something that the borrower cannot use because construction has not progressed sufficiently enough; and
The interest rate, also known as the margin. This is charged on the drawn balance of the loan only, not the full facility amount. The interest rate is either quoted as a fixed cost for the term of the loan or alternatively it is set as a margin over an index rate, e.g. the bank bill swap rate.
The latter two components of the fee structure are what comprise the most confusion for borrowers when comparing competitor offers.
For example, a high line fee on the facility limit, with a low interest rate on the drawn funds, can have the same dollar cost as a low line fee and a high interest rate. A line fee of 3.75 per cent and a fixed interest rate of 5 per cent may appear to equate to an interest rate of 8.75 per cent, but in reality, annualised cost of that money may actually be as low as 7 per cent.
Using the same example of 3.75 per cent line fee + 5 per cent interest, the dollar cost may be the same as a line fee of 1.50 per cent and an interest rate of 9 per cent.
This will largely depend on the drawdown profile of the debt and how long the debt is undrawn and thus paying a line fee on a facility that cannot be utilised.
Some private debt funders will deliberately pitch the line fee high and the interest rate low to “quote” an overall rate that appears lower than what it actually is, i.e. a cost of funds is “sub 10 per cent”.
What Drives Pricing
In determining what pricing is applied to private debt, three key items are considered by the private debt funder:
The risk characteristics of the transaction, i.e. what are the loan to valuation ratio’s, equity contribution, pre-sales and or takeout/repayment source, the track record of the sponsor, quality of the builder etc;
The fact that the pricing is usually quoted as a fixed rate for the term of the facility, not linked to an index rate such as a bank bill rate and thus some premium and margin is built in to protect against future interest rate rises; and
What is the underlying return sought by the private debt funder providing the funding.
All private debt funders will have a different cost of funding. For example, a pooled fund may have a lower cost of funds as the capital is ready to be disbursed and therefore the opportunity cost of not investing those funds becomes greater the longer they are not invested.
Conversely, a sole investment entity may only invest in selected transactions from time to time based purely on a higher return being achieved.
Due to the increase in demand for non-bank capital, private investors are seeing a greater number of opportunities and as such seem to price based on the highest return available compared to a trading bank that will price largely based on perceived risk.
In addition, performance hurdles for many fund managers mean they cannot accept transactions that are less than a certain % IRR.
This means that a developer can end up paying the same interest rate for a 60 per cent LVR loan as they would for a 65 per cent LVR loan which seems at odds to the risk of the transaction.
Clearly financiers that have a cost of capital which allows them to price a transaction based on risk are going to be more competitive.
The Bottom Line
For borrowers there are two key takeaways:
Understand the components of the pricing quoted, i.e. high line fees/low interest rates. The best method to determine whose pricing is lower is to run the pricing offers through your own cash flows and determine the dollar cost of all offers, and;
Understand who the lender is, how they source their funds to gauge their likely cost of capital and therefore what their drivers and constraints are for doing the transaction.