So what could go wrong? And how to make sure it doesn’t?
Overleveraging
Let’s say it’s been a great year. Occupancy or volumes are up. The strategic plan calls for renovation. And numbers are trending up, so the amount of debt the property or facility can afford appears strong.
Hold on — what is driving the upward trend, and is it sustainable? Basing debt capacity solely on the strength of very recent financial performance is an easily avoidable misstep. Avoid determining how much a facility can afford to borrow based on annualized cash flows of the past four, six or even 12 months. The financier brought in to provide access to capital should provide a thorough debt capacity analysis that considers stabilized and sustainable cash flow. This analysis may also include stress testing of debt service coverage under various hypothetical situations that could impact operations and cash flow.
A comprehensive market study can be an important and valuable tool here. A mistake can be made, though, when an organization sees in a market study only what it wants to see. Borrowers must objectively evaluate every element of the market study to create the most appropriate development plan, recognizing that true affordability means not “we can pay for this,” but “we can pay for this even if…”. Market studies should provide justified, realistic and quantifiable support for development and avoid “pie in the sky” assumptions.
Related to overleveraging, borrowers should be aware of overdesigning. Architects and other designers should be aware of the project’s debt capacity so they are able to model an appropriate project the first time, rather than trying to value-engineer backward into an affordable price range.
Introducing: The One and Only Financing Option
In Michigan in 2009, two hospitals issued debt for similarly-size projects at about the same time. Both qualified for the same financing options. One chose to issue traditional unenhanced tax-exempt bonds — a commonly used method familiar to the hospital. At about the same time, Baraga County Hospital combined federal mortgage insurance (a program introduced in 1968 but less commonly used) with Build America Bonds, a temporary option created by the American Recovery and Reinvestment Act. Baraga’s effective interest rate was 2.36 percentage points lower than the other hospital’s, ultimately the result of taking the time to consider and analyze the financing alternatives available. That first hospital could potentially have realized an estimated $19.5 million in present value savings if it had evaluated other options.
This isn’t to say that unenhanced bonds are never the best option. But the best option is going to change with the markets, with legislation and with a borrower’s internal credit characteristics. Consider dual-tracking or pursuing multiple financing options at once. This can provide a borrower the ability to quickly change financing structures to take advantage of a condition that has made one funding structure more favorable over another. An investment bank or mortgage bank that is qualified to offer every financing option can provide an objective opinion as to which would be most appropriate.
The local community may also be able to assist in financing plans. Work with your financier to identify the various entities in your area that could participate in a financing, whether it be a local bank or a finance authority with the capacity to provide permanent debt financing.
Floating In Deep Water
Interest rates have been at levels last seen in the early 1970s. With little room for variable rates to decrease, it is important to consider the potential impact of rising variable rates. If rates rise on variable-rate debt, payments on that debt will rise, impacting budgeting ability and net income. Working with a financial adviser or lender, a borrower can determine how high is comfortable, and then take steps to ensure payments stay within that range.
Caps and collars can be used to set interest rate ceilings and floors on a variable rate, providing a predictable band of interest rate volatility that can help in budget planning and investment portfolio allocation decisions. Swaps can also be used to effectively trade variable-rate payments for fixed-rate payments. But it’s not always necessary to hedge or swap the entire amount of variable-rate debt, and may not be wise to do so.
Borrowers often do not realize that they may already have a natural hedge against rising rates: an investment portfolio whose earnings rise as interest rates rise. Hence, the net variable rate exposure can be defined as an organization’s outstanding variable rate debt, minus offsetting floating-rate investments (the natural hedge), minus floating-to-fixed interest rate swaps.
By changing the asset allocation and the type of investments in its portfolio, an organization can impact the amount that can be considered a “natural hedge,” and attain the desired net interest rate risk exposure. The more this natural hedge is utilized, the less a borrower may need to swap to maintain predictable cash flow, and the less the borrower will pay in swap transaction fees.
Borrowers cannot control the markets or external factors during a financing. But those that are aware of their limits, aware of the fact that multiple options exist for almost any project, and that objectively utilize the resources and reports available to them will have a smoother path to the closing table.
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