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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   September 2017

Construction Loan in Two Steps

Financing a building project requires short- and long-term thinking

c_2017-09_barnes_spot.jpgTypically, there are two different loan types required to finance a building project. Construction loans provide only temporary financing and are expected to be paid off when the building is ready for occupancy.

At that point, either the balance on the construction loan is paid in cash, or long-term financing is obtained. The construction lender is in a vulnerable position if the builder lacks the resources to pay off the loan balance or is unable to obtain long-term financing when the building project is completed.

Consequently, some lenders will require a takeout loan commitment from a permanent lender before agreeing to lend on certain types of construction projects — such as office, warehouse or retail projects that lack signed leases with major tenants or have failed to achieved a certain level of space commitments. This two-step process, of course, provides another opportunity for the mortgage broker to find a long-term lender.

Frequently, commercial mortgage brokers will successfully source and place a construction loan with one of their lenders. If properly negotiated, a broker will reserve the right to find a long-term loan to pay off the construction loan when the project is completed. Even better, the construction lender may have an interest in funding the long-term loan as well as the construction loan.

One potential issue with this arrangement is the term lender may object to paying a second fee to the mortgage broker for the same loan. If, however, the broker bargains, documents and structures the transaction properly, the one-time origination fee will adequately compensate the broker for their time, work and effort. A side benefit, but equally important, is expanding a solid relationship with the lender, which will open the door to future loan transactions from the broker.

Financing alternatives

Experienced builders can normally obtain open-ended construction financing without a permanent takeout loan. Inexperienced builders will likely need to secure a long-term takeout loan before they can obtain construction financing, however. In the latter case, the lender may require the buyer to obtain preapproval for a long-term loan before they will close on the construction loan. All options discussed provide opportunities for the mortgage broker.

Also, there are lenders that will not require a takeout loan on a well-located project by an experienced developer or investor, assuming the construction lender feels comfortable that the originating broker can readily find permanent financing when the project is finished. The broker and construction lender know the full market value of the project is not realized until construction is completed and income is stabilized.

In one scenario, the borrower secures a construction loan, and when the construction project is completed and reaches stabilized occupancy as defined in the long-term lending agreement, the borrower then obtains a permanent loan through another broker-arranged lender that is used to pay off the construction loan. This is the two-loan approach and the advantage is that the buyer and the mortgage broker retain the flexibility to negotiate the best terms available on the permanent loan.

The other approach is a single-close construction loan. In this scenario, after the building is completed and reaches stabilized occupancy as defined in the long-term lending agreement, the lender will automatically convert the construction loan into a permanent loan and the amortization process begins with the payment of principal and interest each month. The two benefits of the single-close loan is the borrower, with the broker’s assistance, only has to negotiate for one loan and only has to pay one set of closing costs.

Underwriting gauntlet

It is essential to understand there is a detailed process for converting a construction loan to a longer-term traditional mortgage after construction is completed. The term lender must be assured that the transaction has been structured and documented in such a way as to ensure an easy, uninterrupted transition.

With a single-close loan, for example, the commercial mortgage broker must recognize and document the initial file based on the assumption that the lender will underwrite a single-closing, construction-to-permanent loan centered on the terms of the permanent financing. If, for whatever reason, the permanent financing terms change during the course of construction, the loan will be underwritten again, with no assurance of approval, causing a great deal of added risk for all counterparties involved.

Once a project achieves the ‘stabilization’ point, the construction loan is ‘taken out,’ or replaced, by longer-term financing. 

To ensure a smooth and timely closing, the mortgage broker should emphasize for the borrower/investor that the construction-to-permanent loan will be based on the assumption that, during the process of construction, there will be no material change in the borrower’s financial position, no significant design changes, no major cost overruns and no increase in the loan-to-value (LTV) ratio.

Addressing concerns

At a Glance

Construction loans

Following are some of the factors a lender will consider in reviewing a request for a construction loan:

  • Zoning, permits, design requirements and regulatory issues;
  • Financial feasibility, stabilization point and outstanding letters of credit;
  • Required inspections, certificate of occupancy and market rents;
  • New competition, market timing, changing demographics; and
  • Economic or real estate market conditions, market appeal and location.

A commercial mortgage broker must be acutely aware and prepared to discuss with the term lender the potential events that could happen during the construction period to disrupt the original plan, resulting in more time needed to complete the project and — probably — an increase to the overall cost of the project. Most of these concerns should be addressed by the project’s market-feasibility study, which will analyze the market’s ability to support the proposed development. This study should give the mortgage broker and lender some degree of comfort regarding the potential risks. Remember, however, that time changes everything.

The knowledgeable broker will work to stay ahead of the curve and be prepared to address any issues the term lender identifies. These issues may give the lender sufficient reason to decline the loan request. The broker must stay abreast of these changing concerns and have a joint strategy with the builder, borrower and term lender to deal with these potential developments. Additionally, there are a host of other potential concerns that will be considered and reviewed by the term lender before paying off a construction loan, all of which should be anticipated and addressed by the broker.

The appraiser, for example, may decide the pro forma rents for the completed construction project are above market value and choose to use lower rent levels to determine the value of the building. Lenders will be cautious of financing properties based on high rental prices that may not be sustainable. Of course, the lender also will have a minimum set of expectations for the debt-service coverage (DSC) and LTV ratios that will be applied to all projects.

These are only a few of the concerns the long-term lender will address before loan closing. The originating broker should be aware of these potential issues and be prepared to ease the lender’s concerns. Third-party reports such as an appraisal, an environmental assessment, a property survey, title and other insurance, as well as the construction-loan agreement, will help mitigate some of the potential concerns associated with construction lending. Obviously, it’s a very document-intensive process, but that documentation is very necessary to ensure perfection of an unencumbered lien.

Loan underwriting

One of the first steps in commercial real estate loan underwriting is confirming the stabilized net operating income (NOI) of the property. When transforming a construction loan into a permanent, long-term loan, the rent-roll pro forma figures will be reviewed for the initial underwriting; however, the lender may decide to use a different NOI calculation. Adjustments may be made, for example, that decrease rents, increase the vacancy rate and/or modify other expense factors, resulting in a lower NOI than the project sponsor projected.

The lender’s objective is to stress-test the assumptions and confirm the transaction can still provide cash flow for the required debt service. Consequently, in the mortgage broker’s initial write-up and file presentation to the lender, it is advisable to apply this same level of analysis to demonstrate an understanding of the process and to quickly put the lender’s mind to rest regarding these risk issues. After re-examining the NOI, lenders will apply their specific lending guidelines used as criteria for other real estate projects, including the LTV and DSC ratios.

Once a project achieves the “stabilization” point, the construction loan is “taken out,” or replaced, by longer-term financing. The broker’s file should estimate the dollar level and time needed to reach “stabilization.” Stabilization means the point at which the project realizes the desired income by achieving a certain level of lease-ups and/or net income.

The takeout loan may be subject to further documentation. The permanent lender may want copies or assignments of other documents from the construction lender’s file and may include a land-purchase agreement, certified plans and specs, construction contract, line-item budgets, disbursement schedules, inspections, construction-loan agreement, appraisals, environmental assessment and property survey. Ideally, this information will be obtained and presented to the term lender by the mortgage broker.

• • •

The processes, standards and criteria for obtaining a construction loan will, of course, vary from lender to lender based on perceived risk, transaction size, project location, builder experience and the lender’s prior experience with the builder. Most importantly, it pays to keep in mind that there is never a cookie-cutter approach to this type of financing.


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