We are in a competitive financing environment, with debt and mezzanine lenders competing for borrowers. As alternative lenders step up their activity this year, the stretch senior loan is a hybrid product that borrowers can turn to.
Stretch senior is a loan provided by a single lender that goes to a higher leverage position with more layers of debt, according to Ari Hirt and Jordan Ray, managing directors of the debt and equity finance group at Mission Capital Advisors, a capital markets solutions firm. These loans offer leverage going up to 85 percent of the loan’s value in one fund. Hirt and Ray see its use increasing for value-add transactions.
“This is not a mainstream product. It is a good idea, but hard to execute. It brings together two types of financing philosophies that don’t often exist together. Few companies have the internal DNA to do that,” says Jay Rollins, managing principal with JCR Capital, an alternative investment manager that provides capital solutions. His firm offers this product, but “would like to do more.”
A stretch senior loan does the work of both a senior loan (which currently goes up to about 65 percent of a loan’s value) and a mezzanine loan (which covers the second tranche, from 65 to 80 percent), according to Rollins. As a result, borrowers are able to borrow at much higher leverage with one loan product, instead of securing financing from multiple sources. Stretch senior loans work best for transactions under $20 million, Rollins notes, because they are easier to execute when there’s limited competition with mezzanine loans.
Time is increasingly of the essence with stretch senior financing. The lender is lending on both asset-based and cash-flow based principles, taking a short-term risk as the project is being renovated, according to Patrice Derrington, Ph.D., director of Columbia University’s MSRED program and its Holliday associate professor of real estate development. “The key point about stretch senior is [it] has to have a short-term time constraint, otherwise the risk-return doesn’t make sense for the lender,” she says.
Lenders are willing to make stretch senior loans because they have a senior claim of security on the asset and cash flow and will make a higher return, Derrington adds.
Sources call it a hybrid product because it combines financing principles of both traditional senior loans and mezzanine loans. Borrowers are able to borrow at much higher leverage with one loan product, instead of stepping up financing in two rounds.
Borrowers are sometimes resistant to using stretch senior loans in cases where their potential cost outlay makes it cheaper to get a mezzanine loan, according to Rollins. As an example, Rollins says a traditional loan may be 70 percent loan-to-value (LTV), priced at 6.0 percent, plus one percentage point in lender fees, while the stretch senior loan may go up to 85 percent LTV, but is priced at 8.0 percent plus one percentage point in lender fees.
Borrowers should weigh the pros and cons of the senior stretch option. It can be more expensive upfront, but does offer them seamless lending and an increased sense of security.
“Stretch senior ends up stretching leverage, but makes it easier for the transaction to close. So the borrower is not dealing with two different lenders. Although it is priced higher for the borrower, there is ease of execution and a level of certainty at loan closing,” Hirt says.
What is unique today is that many non-bank lenders, including the mortgage REITs, are offering stretch senior, according to Ray. “They are not taking it as a mezzanine loan with equity collateral, they are just taking it as a mortgage collateral. It’s done as a mortgage loan provided by a single lender at a higher leverage point.”
Borrowers choose stretch senior as a shield against risk. “I’d rather have one lender, have a mortgage loan and not pledge membership interest—I don’t want to give up a pledge of equity, this shields me in foreclosure. You are shielding yourself from risk, there is less risk at close, less risk in that you don’t have to pledge equity,” Hirt says.
Lenders are willing to accept lower returns on deals today because they are often choosing to hold onto their primacy rights on stretch senior loans and find other ways to earn returns, he adds. Although a stretch senior deal gives the lender a senior position to sell later in securitization, lenders are actively holding on to the notes instead.
“Today, we are not seeing as many of those stretch seniors being sold post-closing,” Hirt says.
Gauging the use of stretch senior financing may help investors predict where they are currently in the commercial real estate cycle. “If people start doing more equity plays, or if you see stretch senior going to 90 percent of the stack and charging yield-only pricing, that is a top-of-the-market sign,” Rollins says.
