Enterprise Finance: Why Not Us?

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5 min read

REITS do it. U.K. housing associations do it. Even educated non-profits do it. Want to do it. Want to go enterprise finance?

In enterprise finance, instead of individual governance and financing for each property on its own, a sponsor finances all of its properties under one master loan, and all equity holders have shares in one master ownership vehicle. All loan covenants are applied to the portfolio as a whole, not each project in isolation, so all expansion or contraction of the facility occurs on a pooled basis.

We in the U.S. are used to project finance, where every property stands entirely on its own (regulatory agreement(s), note and mortgage, soft financing, equity investment, entity governance). Everything we do is predicated on minting up a new special purpose entity (SPE) for each property and then financially engineering its brains out to get it closed.

Does a mission-oriented lender’s holding of a third mortgage to secure its soft loan really add any security? Or is this merely tying down poor old Gulliver Apartments into innovation immobility?

Imagine instead an entire portfolio financed with one senior loan, one pool of investors (all with shares in the aggregate pool), and one consolidated financial statement. With effectively one stream of net operating income, diversified across many properties and geographies, if you wanted to refinance, you would refinance that single loan, adjusting the size as needed. If you wanted more cash – to renovate a particular property, or to seed your next transaction – you would simply flex the master credit facility subject to its aggregate debt service coverage (DSC) and loan-to-value (LTV) ratios. To sell a property, you’d need only one lender consent and one investor-pool consent.

Sounds like heaven, doesn’t it? So why don’t we do it?

In fact, REITs in the U.S. already do. And in affordable housing, British housing associations have done it for decades.

As we grapple with reinventing our value chain and revising our sources of debt and equity, why not explore enterprise finance?

There’s the obvious hurdles:

  • We’re used to it.
  • We award resources property-by-property (particularly with low-income housing tax credit).
  • Our value chain linkages reinforce project finance. Our entire debt and equity value chains – everything from LIHTC allocations and awards through loan product types, equity syndication, and even the active participants – are oriented toward project finance rather than the perpendicular approach of enterprise finance. Moreover, the chains are interconnected, so changing one requires changing all.
  • We love compartmentalized non-recourse debt. Enterprise finance is effectively cross-collateralized, which frightens those used to being able to default Property F without worrying about Properties A, B, C, D, and E.
  • Unwinding a project-financed transaction is hideous. Anyone wrestling with a post-Year 15 LIHTC property has experienced the stalemate. Everyone wants the investors out (including the investors), but there is no mechanism to accomplish this that makes sense for everybody whose consent is required.

If we want to adopt enterprise finance, some things have to go away:

  • Our blinders regarding “commingling of funds.” The standard HUD or HFA regulatory agreement requires funds from Property A to be sequestered from all other properties as well as from the sponsor’s own capital. But we can distinguish fund sequestration from fund expenditure authority from collateral encumbrances and from regulatory accounting. We can have entity-level reporting, and entity-traceable incentive fees or soft-debt distributions – and we should.
  • Individual property cash-flow and refinancing limitations. The mania that not a nickel should escape the clutches of some soft lender or regulator may be laudable as an anti-fraud or anti-scandal vaccine, but it’s brutal on property viability. The typical LIHTC property likely spends more money computing its minuscule allowable distributable cash than the cash it triumphantly distributes.
  • Sponsor guarantee phobia. If the property is not its best collateral, the sponsor must be. For that, grown-up sponsors must become comfortable with much toothier and longer-lasting guarantees.
  • Property-specific equity investors. Either we eliminate investors entirely (e.g., as in a non-profit’s buyback of the LIHTC limited partner interest after Year 15), or we find a way to trace (say) LIHTCs and Community Reinvestment Act dollars through a pooled structure to individual beneficiaries. For CRA, much of this has already been figured out.
  • Capital-provider unwillingness for sponsors to accumulate meaningful equity.  Enterprise finance is predicated on equity accreting. The balance sheet of a typical U.K. Housing Association would shock you in its size, liquidity, and robustness. A low-DSC aggregate portfolio, on the other hand, is a recipe for failure.
  • Undercapitalized, under-sized sponsors. The enterprise-finance model works only when the enterprise is large enough so that financing the parent is a much lower credit risk than financing its swarm of SPEs. Enterprise finance implies big, which implies it’s a post-consolidation emergence.

Despite these obstacles, it’s evident that enterprise finance has significant benefits and can become the backbone of a financing system – as seen in its dominance among both U.S. REITs and U.K. Housing Associations.

(Next Month: The downsides, and why nevertheless I think we can and should explore enterprise finance.)

Got a question you’re burning to have answered?  Email it to [email protected].

David A. Smith is CEO of Recap Real Estate Advisors, a Boston-based firm that optimizes the value of clients’ financial assets in multifamily residential properties, particularly affordable housing. He also writes Recap’s free monthly essay State of the Market, available by emailing [email protected].