“Where there’s a will, there’s a way.” This adage has never been more relevant for developers looking to finance new building projects. With Federal Reserve Chair Jerome Powell indicating that the Fed will continue to raise interest rates, traditional capital providers with strained balance sheets are pulling back on lending. And given the current economic outlook, many senior warehouse line lenders may also look to pull back on financing, opening the door for a more direct asset-by-asset approach. As a result, borrowers need to seek out alternative lenders that creatively finance their projects – enter nontraditional lenders and loan-on-loan financing partners.
How loan-on-loan financing works
Loan-on-loan (also known as “note-on-note”) financing is a common form of capital stack formation for bridge and construction lenders and offers a perfect example of a nontraditional lending approach that can provide financing for borrowers in a challenging environment. In a loan-on-loan arrangement, a senior lender (such as a bank, life insurance company or specialty lender) makes a loan to a building developer. That lender then secures senior financing for that loan from another capital provider at a lower rate, thereby increasing their margin and allowing them to offer more competitive terms to the developer. The loan-on-loan is collateralized by the loan to the developer and occupies the last loss position in the capital stack.
To illustrate a loan-on-loan capital structure in action, consider a real-life example of a project financed this way: a $34.7 million multi-family residential construction project in Seattle. In this deal, the lender provided a construction loan at a 74% loan-to-cost ratio ($25.7 million), and a second lender financed 55% of that loan ($14.2 million). In a more programmatic financing structure via a traditional lender, this borrower would likely have secured about $20.8 million in financing, requiring the developer to fund $5 million more in equity or other types of junior financing to get the deal done.
Three benefits to borrowers of loan-on-loan financing
Specialty lenders can offer a borrower a more creative approach to funding a project providing a few key advantages over traditional financing:
- Lower rates: One of the most straightforward and attractive benefits that loan-on-loan financing offers borrowers is a lower overall cost of financing. These structures allow lenders to offer higher loan proceeds blended with competitive rates while meeting their own internal cost of capital requirements.
- Simpler process: Loan-on-loan financing simplifies the process of designing the capital stack for the borrower. In a traditional financing scenario, the onus is on the developer to structure layers of equity, preferred equity, mezzanine debt, and senior debt from investors and capital providers. But with loan-on-loan financing, a lender can be a “one-stop-shop” for the borrower by assuming the responsibility of designing a bespoke capital stack that enables the borrower to complete their project and achieve their desired returns.
- Certainty of execution: Lenders that specialize in loan-on-loan financing tend to have shorter closing timeframes and reliable funding sources, which enables borrowers to access capital more quickly than if they were to pursue more traditional financing. In an environment where traditional lenders are pulling back, nontraditional lenders play an increasingly crucial role in facilitating successful commercial real estate transactions.
For example, when a developer in Fort Worth, Texas, required financing for a 226-unit rental multifamily construction project, they worked with a specialty lender who structured a single loan transaction combining multiple layers of the capital stack using a loan-on-loan note partnering with a credit union. This arrangement allowed the specialty lender to fund 80% of the capital stack – with the credit union funding 60% of the loan – and provide the borrower with higher proceeds than a traditional bank could offer, thereby boosting the return on equity for the developer.
Borrowers may perceive non-programmatic financing structures as more complicated than traditional lending arrangements. But in practice, the lender manages the complexity involved in customizing a sophisticated capital stack that meets each borrower’s needs. The result is a simpler process, often at a lower weighted average cost of capital, that gets their deal done. With rising interest rates contributing to volatility in the capital markets, banks and other traditional lenders may be hesitant to fund new commercial real estate deals. But for determined borrowers, a little creativity and teamwork with a lender well-versed in loan-on-loan financing can go a long way.