This has been an interesting decade for construction financing. As the volume of development and number of development groups have increased, so have the complexities and challenges. The days of financing a construction project with 70 percent to 75 percent loan to cost, pricing in the low 200 basis-point-range over LIBOR and a 50 basis point commitment fee are gone, at least for the immediate future.
In 2006, commercial banks held $378 billion in outstanding commercial real estate (CRE) loans, almost 40 percent of all outstanding CRE loans, according to a report by the Office of the Comptroller of the Currency and the Federal Reserve. The size and volume of these deals, however, became the subject of scrutiny. New regulatory frameworks emerged, like the BASEL III and high volatility commercial real estate (HVCRE) rules.
Meanwhile, interest rates and the basis points of sponsor guarantees have risen over the past few years—275 to 400 more points higher than LIBOR and an increased upfront commitment fee, respectively—and banks must set aside 150 percent of a loan’s commitment in capital reserves. Couple that with the fact that construction loans—with their monthly draws and administrative requirements—are inherently high-maintenance, and the result is a very different lending market indeed.
Furthermore, to make up for this decreased profit margin, many banks are requiring construction finance borrowers to use other bank services.
Today, owing to the perfect storm of HVCRE and the law of supply and demand, development teams are not likely to get the loan amount and terms of choice from one large bank, and especially not on the first try.
Regional and smaller banks are options, however they have lower limits on how much they can lend on one project and to one sponsor, meaning they can’t meet the full needs of large development projects. Several banks might be required to partner on a project, but that multiplies the administration and risk. Further, many banks today aren’t taking new customers, let alone complex projects like multi-use properties. There’s a reason only the largest developers today are taking a multi-bank route—it all adds up to a continual financing need.
If development executives aren’t going to self-fund that gap or do so through “friends and family,” where can they get the money?
The rise of bridge equity and non-traditional capital
As debt financing becomes increasingly scarce in today’s marketplace, equity has become abundant. Preferred equity and mezzanine funding in particular are becoming increasingly popular choices for closing funding gaps. The trick is knowing what’s out there, having the relationships to make the connectionsand being able to inspire confidence and prove ROI.
Equity providers are selective—it’s their money on the line after all. However, given the abundance of liquidity in the market, many have lowered their expectations for returns and yields.
Non-traditional forms of financing have risen to the fore as well. Life insurance companies, debt funds, pension funds and others are seeing the opportunity in construction lending and have become flexible alternatives to conventional bank financing.
Compared with many CRE funding sources, these alternative sources can offer a great amount of flexibility for the following.
- Property type: Multifamily, hospitality, industrial, office, retail, senior housing, among others.
- Term: The range can vary from less than five years to more than 15.
- Leverage: Any leverage, with more competitive terms at lower leverage, especially 65 percent or less loan to value.
Here’s how construction executives can make financing work today:
- Search beyond the usual suspects. Go to sources that aren’t yet on the company’s list of go-tos, looking nationally as well as regionally.
- Enlist a partner with experience, connections and access to the full range of capital sources. Ideally, they’ll be able to bring the right capital sources to the project—such as preferred equity and mezzanine debt to fill a funding gap—and guide all sides into a deal and relationship that’s mutually beneficial.
- This partner should be proactive, researching capital sources and establishing relationships year-round, so they’re able to present a richer range of options when opportunity arises.
- Make reputation a top priority. Lenders and equity partners can afford to be picky in today’s market. Don’t give them a reason to turn a deal down.
- Start now. Sixty days before closing used to be enough time when choices were plentiful. But times have changed. Allow several months, even half a year, to find partners and lenders and get the details in place.
Where are the deals happening?
Continue to look at gateway markets: New York, Boston, Washington, D.C., Miami, Atlanta, Chicago, Denver, Houston, Dallas-Fort Worth, Texas, southern California, San Francisco and Seattle. In terms of property type, enduring strength in multifamily is being matched by the continuing rise of industrial, particularly ecommerce-driven storage.
