How to score construction financing in 2018
Why is attracting construction financing different “in 2018” than any other year? We need some quick backstory.
In the mid 00's, we had one of the hottest real estate markets in memory. Prices up, leverage up, underwriting standards down… it ended up spiraling out of control and led to the Global Financial Crisis (GFC). Then starting in 2008 and for a couple of years, the real estate market virtually froze as bad deals were worked out, prices bottomed out, and the world (and major governments) took a closer look the role of real estate finance in the GFC. Many lenders, including major institutions, were in bad shape, some going “belly up” after years of chowing down on bad mortgage-backed securities.
For those savvy investors who began getting back into buying and developing circa 2010, a new cycle kicked off that saw strong recovery in real estate fundamentals, particularly in core and growing markets, that continues to this day. Real estate has seen some fantastic returns over that period, and a lot of construction. Investments from that period are quite a vintage.
But let’s hop back one more time. After the crisis, major western governments pointed the finger at these major banks and lending institutions that let the ____ hit the fan, and decided to punish, regulate, and require more reporting on their activities. US regulations like Dodd Frank and the introduction of the idea of “HVCRE” (high volatility commercial real estate) tampered the ability of major banks to lend aggressively on commercial real estate, particularly construction. While now in 2018 some of Dodd Frank is being rolled back, there’s still a lasting effect that has enabled many non-bank lenders to compete more strongly for traditionally bank-dominated loans.
From 2016 until today we’ve heard those around the industry calling this cycle “long in the tooth”, and postulating how close to the top of the market we currently are. There’s a natural worry that too much price appreciation is a signal that the industry is repeating the all too familiar habit of overheating and needing to be cooled off. During cooling periods, new development deals can be hit hardest.
Have a plan
Your plan is the basis for closing financing for your real estate development.
The first thing a lender will scrutinize is that the project’s underwriting passes muster. That means that the fundamental financial assumptions line up with reality — the pace of lease-up, rents aligned to market data, and costs in line with current industry norms.
Note: the cost of financing should be included in your pro forma budget. Quick example with round numbers: If a project will take $10 Million to build, a 50% loan at 10% will still need to budget $500,000 of interest payments. This brings the true budget size to $10.5 Million, and will mean the sponsor putting in $250,000 for interest payments.
Not only should the numbers make sense and tie out, but the execution ability of the sponsor (the key borrower in charge of developing the project) needs to be displayed. That means experience and a track record of success.
Key hurdles passed
Great plan, great borrower… what else can a lender ask for?
A few more things, it turns out. The local government typically has within its purview the ability to approve or reject development plans, and zone land for particular uses and then to approve or reject specific development plans (the entitlement process). This will vary pretty widely between different locations, which is another reason the lender will want an experienced developer that understands these processes and players involved to lead the project.
A construction lender doesn’t want to absorb the risk of these hurdles, so you’ll need to have your ducks in a row before locking down a construction loan and drawing funds.
Know the players
Banks provide some of the most cost-effective construction financing around, if not the highest leverage. Some of the regulations we touched on above make it harder for big banks to go high on construction loan leverage because they need to reserve extra capital on their balance sheet to do so.
Community and regional banks are also solid options for construction loans within their footprint, particularly if the borrower can become a key client.
Debt funds and private lenders
Debt funds are investment vehicles specifically set up to buy or originate loans, while private lenders may be using their own money to fund. Any flavor of lender in this bucket will typically be “more expensive” (higher rate) than a bank or credit union, but will also typically be more flexible, with the potential for higher leverage and easier approval. That flexibility can also carry over to the construction draw/servicing experience, where approval can be made directly for a draw without lots of red tape or a third-party construction consultant that may be required by a banking institution.
Layer the cap stack
Sometimes as a developer you’ll find yourself in a situation where a senior loan doesn’t provide enough funding proceeds to complete your project. In that case, layering up the capital stack may be in order. Refer back to our previous blog post: When the Capital Stack Gets Mezzy
If all of the above won’t get a developer to the amount of capital necessary to complete a project, looking for additional sources of equity is the last layer to consider. Here there is still some variation between Preferred Equity (one step more senior than the developer/sponsor), JV equity (equal standing with the sponsor), and other custom structures. We’ll be sure to cover different flavors of equity partnership in a later post.
Work the process
So you have a plan and you know the players. Now work the process.
Step 1: Professionally underwrite the project. This is the foundation of the deal — reasonable data fed into a logical model about how the project will perform and create value.
Step 2: Identify the right lender contacts based on the project’s parameters — location, size, asset class, desired financing terms.
Step 3: Prepare an offering memorandum showcasing the project’s key details, highlights, and pro forma financials.
Step 4: Solicit feedback and loan quotes from the lender contacts identified in step 2.
Step 5: Negotiate and sign the best term sheet to proceed with the selected lender’s application process. From this point, the process will vary by lender to get to close. Banks will typically have a more formal credit committee to get to your lending commitment.
Many developers will use a Capital Advisor (there are multiple terms for similar professionals in commercial real estate including investment banker, mortgage broker, mortgage banker, etc) to complete this process. While these are typically intermediaries that collect a fee at closing, you’ll be leveraging that professional’s network, experience, and trust built up from a career as a real estate financier. A good Capital Advisor can widen the net of potential capital sources, guide you through each option available, and ensure superior execution. After all, neither the experience nor the relationships happen overnight.