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   ARTICLE   |   From Scotsman Guide Residential Edition   |   February 2015

The Rise of Small Builders

Working-capital loans are the building blocks of niche construction

The Rise of Small Builders

Homebuilders are once again becoming an engine of growth for the U.S. economy. Many small builders remain cut off from bank financing, however, and may need help from mortgage brokers who are willing to work with private lenders. These small builders — who frequently focus on infill locations in urban areas — are seeing some of the highest profit margins in the industry. Although large builders are often happy with 12 percent gross margins, some small, niche builders in high-value markets see gross margins of 20 percent or more.

As the source of working capital for today’s niche builders, private financing has become a critical building block in this corner of the industry. Mortgage brokers who want to work with developers may have to think outside the box and learn different ways to package loan requests to private lenders to help homebuilder clients acquire properties, start construction and complete projects.

Brokers who are looking to expand into the residential construction market first must know the basics about the following four types of loan programs available to niche builders:

  • Acquisition-only loans
  • Construction loans
  • Construction-completion loans
  • Inventory-financing loans

Each type of loan caters to a particular kind of project, so it’s important to know the ins and outs of each. Here’s a breakdown of the four loan programs and the situations to which they apply.

Acquisition-only loans

Some of the most profitable single-family projects today involve an unappealing home on a great lot in a desirable neighborhood. Typically, a builder’s strategy will consist of purchasing the home, creating plans, getting building permits, demolishing the existing structure and building a brand new house.

To beat the competition and gain control of these properties, developers must conduct due diligence and close quickly — often in two to four weeks in competitive markets.

Offers cannot have any financing contingencies either. In this situation, an acquisition-only loan can be a great fit.

The developer simply needs a short-term loan, perhaps for four to six months, to have enough time to design the new home and get the required city approvals. An acquisition-only loan also gives the builder’s broker time to shop for a good construction loan for the project. This new loan may come from the same lender that provided the acquisition loan or from a different lender.

Brokers working on acquisition-only loans should know that some private lenders will reduce origination fees from their usual rates for short-term loans. This can help lower your client’s costs. Alternatively, some lenders might discount the points on a subsequent construction loan if they made the original acquisition loan on the same property.

Construction loans

A construction loan usually finances the cost of acquiring a lot and building a new home. The lender will want to review the budget for the entire project and become familiar with major design decisions, the profile of the target buyer and comparable sales in the neighborhood.

For acquisition-only loans, lenders fund the entire loan amount at the time of acquisition — that is, there’s a single funding event. In contrast, construction lenders increase the loan amount over time, distributing cash when the builder reaches various milestones on the project. Construction lenders typically arrange to have an inspector see the property prior to each funding draw. Usually, builders pay the fees for these inspector visits.

The site inspection ensures that the collateral property has actually been improved prior to each construction draw. Construction lenders want to know that all the work has been done properly before increasing the amount of money at risk on these loans.

Inspectors also will make sure that there are no mechanics’ liens on the property and that all subcontractors have been paid. If borrowers default, lenders want to know their money went to paying the people who worked on the house. Otherwise, they might end up paying for the same work twice.

Construction lenders sometimes must take over projects that they funded, but taking over a new home midway through development is more challenging than taking over an existing building that is ready to sell. This is why there are fewer single-family residential construction lenders than lenders that finance light renovations. Thus, brokers should vet their builder clients carefully to avoid losing valuable relationships with construction lenders over shoddy workmanship or payroll issues.

Construction-completion loans

In construction-completion loans, lenders make loans on projects that are in the midst of construction. This situation might arise for one of several reasons:

The project goes over budget. If the builder doesn’t have enough cash to cover a cost overrun, the existing lender may not be willing to increase the size of the loan. If the project is far enough along, however, a broker may be able to find a new lender willing to focus on the value of the finished project and provide higher proceeds than the existing lender, thus addressing the developer’s cash shortfall.

A new opportunity arises. Some-times, developers with large amounts of equity in projects nearing completion need extra funding because of new opportunities that won’t wait. For example, a developer may want to purchase a new project before completing and selling an existing home. In these cases, builders can often tap into the equity of the soon-to-be-completed existing project to fund the new opportunity.

Other funding gets delayed. Developers may experience unexpected delays in receiving other funds that they intended to use to complete construction. For example, if a developer owns a business and is using profits from the business to finance construction, the real estate project may stall if the business doesn’t get paid on time.

Problems arise with the existing lender. There’s a variety of difficulties that developers can experience with existing lenders. Perhaps a lender hasn’t been responsive to construction draw requests or doesn’t have enough money available to meet funding commitments. Other times, the chemistry between the lender and borrower simply may not exist.

A broker can help in these scenarios by finding alternative lenders to make construction-completion loans that effectively take out the existing lender and fund construction draws until the project gets completed. These types of loans are repaid when the projects sell.

Inventory-financing loans

Just like car dealerships with new cars sitting on the lot, small homebuilders often have an inventory of finished homes on their balance sheets. Developers sometimes want the flexibility to hold out for the highest offers from motivated buyers on recently completed homes. Builders also may prefer to put homes completed near the end of the calendar year on the market after the holidays when buyers are more active. Inventory financing loans can help builders ride out these short periods between completion and sale.

Inventory lenders focus more on the value of the finished property than the builder’s costs for inventory loans, so brokers must know the market. In many cases, builders have created significant value and can tap into that value with a cash-out refinance to provide cash for new projects while they wait for buyers to purchase their finished homes. Inventory loans tend to be shorter-term loans, so some lenders may be willing to discount the origination fees on these deals, just as they do with acquisition-only loans.

•  •  •

Small, urban, residential homebuilders are experiencing a renaissance today, particularly in high-value coastal markets. The housing stock in this market is ]generally outdated and undersize compared to what today’s affluent buyers are seeking. Many buyers will also pay a premium for a new or updated luxury home close to high-paying jobs because of worsening traffic congestion.

Delivering high-end homes in urban settings requires the unique skills of small homebuilders rather than the large builders who led the industry in the past. Brokers who can secure working capital for these businesses by partnering with creative lenders that understand the needs of small residential builders can create a healthy business in this niche by helping broker loans throughout the entire pipeline from acquisition and construction to eventual sale of the project.


 


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