AF Bornot Dye Works is a loft apartment and retail project in central Philadelphia that involved the adaptive use and restoration of three timber and concrete factory buildings. Located along Fairmount Avenue, one mile north of Philadelphia’s City Hall, the surrounding Art Museum area is one of Philadelphia’s hottest submarkets, accounting for one-fifth of Center City’s new housing in 2015. The four-story buildings include 17 rental residences on the upper levels and 13,210 square feet of retail space across two lower levels, which has been preleased to neighborhood-serving tenants. In undertaking the project, the developer, MMPartners, built upon 15 years of experience renovating and building scores of residential and retail properties in nearby Brewerytown. The $10.7 million development was funded through a combination of conventional loans, federal and state historic tax credits, city incentives, partner equity, and a $375,000 mezzanine loan from an online crowdfunding platform.
Development Finance
The capital stack assembled for AF Bornot Dye Works is unusually complex for a project of this scale, partly because of its unusual mix of uses, its location outside the Center City core, and the challenges posed by historic rehabilitation. David Waxman, managing partner of MMPartners, is particularly proud that a $10.5 million investment was leveraged with an equity investment of less than 5 percent of the project budget.
More on This Case Study | More ULI Case Studies
Although bringing together this capital was a tremendous learning experience, Waxman notes that “if we did this project today, we would have done this much more traditionally.” Lenders have become much more savvy about urban residential and with historic tax credits in particular. Some lenders now do “one-stop” lending for historic projects, pairing a senior construction loan with a junior bridge loan that is repaid from the pending credits.
Conventional loans. Most of the $10.7 million project budget for AF Bornot Dye Works was funded with a conventional $7 million construction loan from Susquehanna Bank, a regional bank that has since been merged into BB&T. The loan period was 24 months at an interest rate of just over 4 percent, with a six-month option to delay repayment of the interest reserve. The lender was comfortable with the local apartment market but was more skeptical of the market for neighborhood-scale retail and required that 50 percent of the retail be preleased. That hurdle was easily achieved, with over 90 percent of the retail leased by the time the loan closed.
The construction lender was located through a broker, although Waxman notes that “Philadelphia is a big city, but it’s a small place,” where most deals happen through a handful of regional banks that are active in development lending.
Tax credits and incentive loans. Over $2 million in equity funding resulted from historic preservation tax credits available to the project. Because it involves substantial rehabilitation of income property located within a National Register–listed historic district, the development qualifies for a federal income tax credit equal to 20 percent of the cost of construction. PNC Bank syndicated the federal tax credit, resulting in net proceeds of $1.9 million.
In addition, Pennsylvania is one of 33 states that offer state income tax credits for historic preservation. Unlike the unlimited federal program, this relatively new program is funded at just $3 million for a state with countless old buildings. Nonetheless, MMPartners beat the odds and was one of 15 recipients of Pennsylvania’s state historic tax credits in 2015, winning a lottery for a $250,000 allocation that net the project $215,000 in equity.
Financing the remainder of the project meant turning to some unexpected lenders. Although Susquehanna Bank was more comfortable with lending for the project’s residential component, the Philadelphia Industrial Development Corporation (PIDC) was happy to lend for the project’s substantial retail component. MMPartners’ previous work developing office and retail properties, in particular the renovation of a mill in the Manayunk neighborhood, into offices and several restaurant fit-outs, had introduced them to PIDC’s incentive financing for job-creating developments like retail, office, and industrial buildings.
PIDC’s capital project loans provide up to $750,000 in junior-lien debt, with a minimum of one new job created for every $35,000 lent. The loan terms are attractive, with an interest rate of half of prime rate (2.75 percent, in this instance) and a loan term of up to 15 years. Because much of PIDC’s loan funds come from government sources like the Small Business Administration, its upfront documentation requirements can be daunting. “Once you’ve gone through their process once,” though, “it becomes very easy,” Waxman says.
Crowdfunded mezzanine loan. MMPartners also used crowdfunding to finance the project. Fundrise, an online crowdfunding platform, made a $375,000 unsecured mezzanine loan to AF Bornot Dye Works. Crowdfunding—the practice of raising capital online via a large number of small sums—has transformed the business models for industries from board games to presidential campaigns. Massolution, an advisory firm, estimated that more than 1,000 crowdfunding sites around the world raised $34 billion in capital in 2015, with almost 90 percent flowing into established markets like peer-to-peer consumer lending and reward-based projects.
One of the fastest-growing segments in crowdfunding is real estate: the $2.5 billion raised for real estate ventures in 2015 was almost three times more than what was raised in 2014, according to Massolution. Over 100 startups are vying for the market, including Prodigy Network, Patch of Land, Realty Mogul, and RealtyShares. Within the broader context of real estate finance, this is still a drop in the bucket; consultancy RCLCO estimates that it accounts for less than one-quarter of 1 percent of total investment flows.
The crowdfunding market did not exist until 2012, when legislation first permitted crowdfunding sites to market equity securities to “accredited investors” (i.e., high-net-worth individuals), and is poised for further growth now that the U.S. Securities and Exchange Commission (SEC) has adopted regulations permitting the sale of equity to the broader public. In addition, most states have passed their own regulations, which are usually more permissive than the SEC’s. Because crowdfunding has been around for only a few years, the first ground-up development projects funded through the model are just now coming to fruition.
Washington, D.C.–based Fundrise is one of numerous startups that apply the online crowdfunding model to commercial real estate. Fundrise was established in 2011, and so far it has deployed $75 million in capital from 80,000 investors into nearly 100 projects. As at AF Bornot Dye Works, Fundrise typically makes mezzanine debt or preferred equity investments on development projects but also makes investments on stabilized projects and for predevelopment expenses.
Fundrise acts as an intermediary and market maker between investors and project sponsors. It prescreens accredited investors and provides an online marketplace to match projects (and project sponsors) with investors. Sponsors are encouraged to post a portfolio on the site and to recruit investors to a “network” that is notified when new projects are posted. When Fundrise accepts a project for funding, it syndicates the deal by issuing “project payment dependent notes,” backed by a trust that receives the loan’s interest payments, to the ultimate investors. Investor servicing, distributions, and tax compliance are handled by Fundrise.
For the AF Bornot Dye Works loan, MMPartners promised Fundrise investors a return of 18 percent annually over the loan’s three-year term: an 8 percent current return that is paid out quarterly and a 10 percent annual return that is accrued and paid out either at maturity or if the loan is prepaid. The project was marketed to investors on Fundrise in mid-2014.
In July 2014, the deal was fully funded and closed, with 12 investors contributing a minimum of $5,000 toward the loan. More than half of the investors put in the minimum, but the average contribution was $28,000. Fees paid included a 2 percent origination fee and a $5,000 due diligence fee. (Since December 2014, Fundrise prefunds all of its investments, so marketing to investors now takes place after the loan closes.)
Waxman “read about [Fundrise] before they launched” and reached out to get set up on the platform. Waxman wanted to “put up a deal that we knew we could get done,” as a way to build goodwill and a track record with the platform’s investors. That first project was already under construction, with all funding already secured, but allowed MMPartners to cash out some of its equity before permanent financing.
Ben Miller, cofounder of Fundrise, calls MMPartners “the quintessential Fundrise developer. Our sweet spot has been in the space too big for people, too small for large funds.” This often means projects with budgets between $5 million and $50 million and particularly projects that involve complicated (but relatively small) urban infill sites. As Waxman found, construction lenders can be leery of projects that involve less-proven product types, like the upper-floor retail space at AF Bornot Dye Works, and a funding gap can result.
Typically, Fundrise buys out about half the sponsor equity as a preferred-equity or mezzanine-debt position in the capital stack, which can bring a project’s loan-to-cost ratio up to 85 to 90 percent. Preferred equity caps both the upside potential and downside risk, but unlike senior debt the Fundrise position is typically not secured. Miller notes that this funding “looks like equity to the [construction lender], but it’s senior to the developer. It results in less risk than [common] equity.”
As with AF Bornot Dye Works, most of Fundrise’s development deals pay out half the return from an interest reserve as current yield, with the other half of the return accrued and paid out at the end of the term, which usually occurs after permanent financing has been secured. This structure maximizes returns to investors while further leveraging the return on equity. As Waxman says, “You, the developer, keep all the upside. If the project can afford the higher interest rate, it’s a way to own more of the project and offer a high return to the [Fundrise] investor.”
Fundrise usually targets 12 to 14 percent returns for its investors. Miller contends that taking preferred equity provides “a better risk-adjusted return” than the common equity pursued by typical private equity funds. For retail investors, Fundrise’s service and custodial charges are 0.5 percent of assets annually.
From a developer’s standpoint, the due diligence documentation required and underwriting criteria applied are largely similar to a submission for a private equity firm. Miller says that developers who first submit their projects for review “are surprised by how intense we are with due diligence. We’re conservative, value-centric investors. . . . It confounds people that we act like any other private-equity fund, except we are not as bureaucratic.” The company’s due diligence process rejects about 95 percent of submitted projects.
Waxman notes that marketing deals via the platform has helped him “meet some investors who have been great to work with,” especially as his firm graduates to larger deals that might be attractive to private equity firms.
