The Ins and Outs of Fractional Financing
6th October 2011
David Disick's third and final look at securing fractional finance.
So far, your financing discussions have been proceeding well, and one or more bankers is showing interest in your business plan. You feel ready to plant your shovel in the ground.
But the banker’s vault is not yet open. Wrapping up financing can be challenging, if you don’t know what deal terms banks usually expect and which items may be negotiable and which may not be.
Since “forewarned is forearmed,” following is some current information on deal parameters that you may find useful.
III. Getting into the Vault — Negotiating Your Deal Successfully.
A. Size of Your Financing Proposal.
Each large financing institution usually has its own “radar screen.” This is the minimum deal size necessary to attract its attention.
A minimum amount for developer financing is a request of USD 25 million. For consumer financing, it is a projected loan volume of USD 50 million over a two-year period. Larger deals are generally preferred.
Smaller deals, however, may not necessarily be ruled out. Funding would be based on the strength of the deals, the expertise and track record of the developer and his team and the likelihood of additional deals from the same developer.
B. Recommended Minimum Return on Development Equity.
A projected return on development equity of at least a 25% IRR is advisable.
This can be subject to deal-specific considerations, such as, the trade-off between overall return and timing of return and the institution's goals for each.
C. Profit Splits and the "Waterfall" of Distributions
The "waterfall" of distributions is the sequencing of distributions to the capital source and to the developer.
There are various ways the waterfall may be structured. These include:
1) 100% to the institution until repayment of capital;
2) Distributions reflecting the ratio of developer investment to institutional investment;
3) Overall profit potential for the institution; and
4) The institution's evaluation of the project’s strengths and risks.
The capital source normally receives the larger return and receives it first. Splits usually depend on items such as:
1) Ratio of developer investment to that of the capital source;
2) The project's sales performance and actual results relative to projections; and your capital source's investment criteria.
D. Expectations for/Timing of Return of and on Equity.
A workable general rule for a return of equity is 2- 3 years from the date of funding. A good general rule for return on equity is 3 - 5 years from investment date.
E. Competition for Investment Capital.
As a developer, it is important that you be aware of your competition for real estate investment capital and know how to persuade lenders that investing in your development is a more prudent choice.
Many financing sources today are focusing on buying “distress" properties--secondary properties in secondary areas that are deeply discounted—with the hope of an eventual economic turnaround. This is obviously not the profile for typical high-end fractional properties.
Yet, the demonstrable fact is that buying luxury properties favorably (though not "distressed") for fractionalizing can produce comparable or greater profits with more speed and less risk than buying “distress." It is suggested that you show this fact with mathematical models.
F. Return on Institutional Debt, If Applicable.
This will be determined by reference to the base rate in your market area plus additional points or a percentage interest in profit to reflect the perception of increased risk.
G. Consumer Financing.
If your lender offers consumer financing, you may encounter the following issues:
1. Request for developer guarantee of delinquent loans. This can take two forms:
a) A delinquent note is defined as 60 days overdue, with the developer having another 30 days to generate a sale of the fractional interest before the guarantee is called upon.
b) The second, less appealing, is recourse to the developer for a defined period of one to two years.
It is suggested that you not resist these requests because they are almost always included and, by definition, you will be selling to qualified buyers. Thus, your exposure will likely not be high.
2. A "holdback" reserve.
You may also anticipate a request that you establish a "holdback" reserve; namely, an escrow fund of 3% to 5% of each sale for a period to be determined, generally one to two years. Here, it is suggested you resist this request, since the developer guarantee should suffice.
3. Lender remedies on default.
It is suggested you show your lender that it has the same remedies on default by an individual fractional owner as it would have with whole ownership. It is essential to point out to the lender that its right to foreclose on a defaulting borrower will not be prevented or impaired because there are other co-owners of the residential unit.
4. Past performance of fractional mortgage funding.
It is advisable to document the excellent past performance of fractional mortgage funding and show that the current lack of such funding results from general economic conditions unrelated to the quality of these mortgages.
THE BOTTOM LINE
The bottom line is that fractional financing is available.
You will maximize your chances of securing your financing, if you follow these three guidelines:
1. Present and document the significant profit opportunity in the fractional vacation home industry and in your development.
2. Prepare a business plan that includes all the information lenders need to evaluate the financial prospects of your development.
3. Know what financial issues to expect and how to negotiate a mutually satisfactory deal with your lender.
In all that you say and do, you need to communicate confidence in the industry, in yourself and in the strength of your deal. You need to show optimism regarding the profit potential of your development and demonstrate your firm dedication to making your vision a reality. In this way, you can instill in your bankers the confidence they need that will dispose them to look favorably on your development and agree to provide you the financing you seek.
What is the status of the credit market in your area? What are some deal parameters that you are encountering? Please share your experience with fellow site visitors.
Clicke here to read parts one and two of this article.
David Disick is president of The Fractional Consultant. His company helps developers in the U.S. and abroad secure financing. He is an internationally recognized authority on fractional real estate and has written a book on the subject.
Disick will chair the fractional panel of OPP’s Property Investor Show in London on October 13-15. He will also take part in panels on investors and on the U.S. economy. He can be reached at www.TheFractionalConsultant.com, where his book may be ordered.