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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2017

Choosing the Path to Construction Financing

When pursuing a transaction, you have to balance the pros and cons of private vs. bank capital

As we approach the end of 2017, one thing is clear. It has been a solid year for new construction, with total activity over the past 12 months outpacing the previous high-water mark set in 2006, according to U.S. Census Bureau data. Despite fundamental market strength and strong demand for construction financing, however, construction lenders remain highly selective in deciding to whom they will provide funding — and how much.

Banks, while having made a resurgence in commercial lending, are to no small extent hamstrung by the regulatory pendulum that by today’s measure, according to many observers, has overcorrected for the last downturn, irrespective of its severity. Private construction lenders, conversely, fill the gap in loan demand that banks can’t or won’t meet — loans that are fundamentally sound yet bear characteristics that don’t fit neatly within bank underwriting guidelines. 

In the currently evolving lending landscape, as competition continues between banks and private lenders, borrowers — and the mortgage brokers assisting them — have good prospects for finding commercial construction-financing solutions, even for complex projects that require strategic thinking and flexibility. Those solutions, however, are increasingly found with private lenders.

Red tape

Every deal is different — location, size, development team, market — and the days of one-size-fits-all loan underwriting have passed. Lenders are charged with delivering creative solutions, flexibility and speed, key factors driving brokers and borrowers as they sift through the marketplace of banks and private lenders. 

While both types of lenders must adhere to government regulations and prudent underwriting, banks are more strictly governed throughout the entire lending and servicing process than are their private-lending counterparts. As a result, banks have historically carried layers of bureaucracy to comply with regulatory mandates.

Private lenders are typically more streamlined organizations, enabling senior-level expertise and involvement at the project level. This access creates opportunities for shared insights and guidance that larger organizations are often unable to provide. 

Lending expertise

Construction is a fluid process requiring timely action and flexibility. Offering commercial construction-loan borrowers an equally strong expertise in the construction process proves invaluable in timely decisionmaking and advancing capital for a project.

A borrower might need funds to pay a general contractor one week, then additional capital the following week for unforeseen conditions. Subcontractors may need to be replaced during construction, or plans altered. While both lending sources — banks and private lenders — operate under sensible guidelines, experienced private lenders are more apt to consider exceptional circumstances and arrive at a favorable solution to keep a project moving forward.

Banks, while having made a resurgence in commercial lending, are to no small extent hamstrung by the regulatory pendulum. 

Lenders steeped in construction also understand the value of time and how small setbacks affect the path of a project. Private lenders that can arrive at quicker decisions can provide capital — and solutions — much faster, however, saving time and preventing costly delays. 

The broker equation

Historically low construction returns and a challenging regulatory environment make it difficult for borrowers to source optimal construction debt. Now that borrowers are taking a much closer look at the lending landscape, what does this mean for commercial mortgage brokers?

More than ever, brokers are required to have a strong working knowledge of the construction process and the unique needs of each project. It’s crucial that mortgage brokers be well-versed on client projects upfront, enabling any deal complexities to be successfully addressed during the underwriting and approval process.

Plenty of instances exist in which commercial banks can provide the ideal loan structure for a particular project or borrower. Developers or builders that are accustomed to the typical structure for a bank construction loan are well-served by commercial mortgage brokers who seek out a bank with similar favorable characteristics to that of private lenders.

Banks that operate with a high level of construction expertise, relatively flat operating structures with good access to senior management and a keen eye toward the time sensitivity of construction make for valuable lending partners.

Single-source advantage

Banks commonly advance no more than 50 percent to 60 percent loan-to-cost leverage on a construction loan, however, often leaving borrowers to invest more of their own equity or seek out third-party mezzanine debt to compete the capital structure — increasing both deal complexity and the cost of capital.

Private lenders, on the other hand, generally offer terms that give borrowers the ability to use a single debt-capital source. It’s common for lenders backed by private capital to offer construction-loan leverage up to 75 percent of cost, eliminating the equity gap created by lower-leveraged bank loans, given similar loan attributes. 

Private lenders also facilitate a more competitive overall cost of capital. By offering higher loan-to-cost structures, borrowers can replace higher-cost equity with lower-priced construction debt. Private lenders funding an extra 10 percent to 20 percent of the capital stack beyond that of banks ultimately enhance project yield, even though their interest rates are normally above that of a commercial bank.

•  •  •

Commercial mortgage brokers and their construction-loan borrowers, in the current financing environment, are in a unique position to capitalize on a competitive marketplace between banks and private lenders. The current regulatory environment favors private lenders, allowing them to deliver construction loans with speed and efficiency — and from the perspective of a lending partner with expertise in construction as opposed to just a capital provider.

Favorable overall capital structures complete the value-add advantage offered by private lenders, with well-prepared commercial mortgage brokers making a significant difference in successful construction financing. Separately, however, banks that are experienced in all aspects of construction and nimble in size can present an equally sound choice for construction financing. In the end, the choice comes down to what works best for the borrower and the deal in front of them.


 


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