Mezzanine finance - development opportunity

[Yishi Zuo]

Hi folks -

I'm new to BP and real estate (but very familiar with finance and comfortable with early-stage risk in general - I come from the tech venture world).

I'm considering making a small hybrid equity investment / loan to a developer building homes. He has acquired the land, gotten the permitting, has construction financing lined up but needs ~20% cash equity / home.

I know very little about his particular real estate market, and I've never built anything myself. Even if I was the senior lender for one of the new developments, in a downside scenario I wouldn't know what to do with the land / the half-finished or finished (but unsale-able for whatever reason) inventory.

Therefore - I don't want to invest / make a loan in the development JV itself - I would rather make a loan at the parent-co level where there is collateral in the form of completed properties that are generating rental cash flow - they do have mortgages on them. (Also, the developer is reasonably experienced + wealthy and has personally guaranteed some of the existing development projects - but wants to move away from that)

I'm also planning to get some equity in the JV / the broader development company (much less equity than if I were to be a pure equity investor of course). because I do think this could scale to 300-400 homes / year

Of note: These homes are modular in nature - so are faster to build and margins are projected to be attractive.

My questions for you all is:

Have any of you lent to development assets with cross-collateral from cashflowing properties like this? What are some things to pay attention to / negotiate?

Do you know of other opportunities like this? What terms do you think would be reasonable in your POV?

Thank you!

-Yishi

[Dustin Tucker]

Hello Yishi,

I deal with 1st position mortgages on New Construction, I would say that investor capital can be all over the place in terms of rates.  The main things to consider, are the following:

1. Cost overruns, who comes up with the money, how is return effected?  Once your construction loan starts, most banks will not extend any more credit once construction has started.  

2. How much interest reserves are there?  Unless you are building Rental units, the SF Retail market construction market is not doing well, hopefully your builder is borrowing money at sub 10% interest rates.  4 years ago, a lot of builders were only factoring in 3% for total loan costs, I would think that the carry costs would be 10% or more currently.  

3. Like you said in the post, if you can complete the houses, you can rent them out, but that leads to the next question, Do they cash flow? There are DSCR loans that go up to 75% LTV on cash out, and 80% rate and term refi's, which from a builder's perspective are the way out when you can't sell the properties. I think the most interesting part of the DSCR loans is that they are actually going negative on the DSCR, for example I have 2 lenders that will go below 1.0

4. Is the land owned outright or are there loans in place.  This is the #1 reason why most builder's fail, if they own the land, the carry costs are relatively low, but the moment they tap into the land equity for additional capital, is usually the moment they are finished.  I would make sure, I had the 1st mortgage on the land with my investment, for 2 reasons, 1. This ensures that I have something in case **** hits the fan. 2. You make sure that there aren't any loans take out against the land, ensuring that you are safe in your investment.

Hope this helps.