Mortgage lenders that finance construction loans have taken a hit as projects across the nation have been delayed or halted altogether due to the COVID-19 pandemic. As a result, lenders that are still doing construction and land loans have tried to safeguard their cash reserves and have been extremely cautious about where they place money.
Traditional lenders — especially banks — might be the most conservative on this front. If they choose to move forward on a construction deal, it has to make sense on all levels. Regardless of their type, lenders have adjusted their interest rates from prepandemic levels to mitigate the higher risk. As an industry standard, rates as of mid-July 2020 ranged between 10% to 12%. These are up somewhere between 100 and 300 basis points from pre-COVID rates, which were hovering at about 9% not so long ago.
Looking back to February 2020, lenders were aggressively pumping money into the market, but we are now experiencing the polar opposite. Even private construction lenders are quite conservative on the projects they underwrite. Some will still finance new construction but are focusing only on fundamentally sound projects with proven and experienced borrowers. The good news for the commercial mortgage broker is that private lenders have more flexibility than banks and similar lender categories with rigid restrictions.
With that said, private lenders have been regularly garnering a fair amount of new loan inquiries from developers, who are aware that interest rates are at historical lows and want to secure construction financing for a new project. Although low interest rates may be the case for new homebuyers or those wanting to refinance a residential mortgage, developers need to know that the exact opposite is happening for commercial development projects.
Because the capital markets were frozen for quite a while, rates for these types of loans have gone up and the maximum leverage that lenders will allow has subsequently gone down. Prior to the COVID-19 crisis, developers were increasing the number of commercial construction projects in secondary and tertiary markets, and lenders were amenable to financing them. In today’s uncertain market, that is no longer the case. In an effort to mitigate risk, construction lenders are truly focused on moving forward with mortgages for well-located projects in primary markets.
Land sales for future commercial projects also are being shied away from. Although all types of lenders — including private lenders with flexible guidelines — would look at land deals prior to March 2020, they are now extremely difficult to do. They are perceived as far too risky. Across the board, lenders won’t approve a land deal except under special circumstances for that particular market and intended product type.
Meanwhile, developers are still actively looking for opportunities and are generally optimistic, but what they were willing to pay for a development opportunity in February 2020 is not what they will pay now. Borrowers that were in escrow on a land deal that wasn’t locked in prior to the crisis have tended to try to get a discounted price or have cancelled the sale altogether. The thinking here is that if there is more distress in six to 12 months, it would be prudent to hold off and acquire a parcel at a discounted price a little farther down the road.
Despite the various reasons to move forward with construction, commercial mortgage brokers should advise developers to take a hard look at determining whether to commence with a shovel-ready project.
Evaluating the market
The good news for your clients is that prices for labor and materials are starting to come down. So, while the commercial construction market has implemented a higher cost of debt, some developers are opting to pay higher rates and get projects going now while they can save on other budgeted items.
Depending on where their property is located and what the asset type is, some developers are confident that their projects have the fundamentals that will meet the demand after completion. A borrower may figure that if rates go down six to nine months from now and the project is still underway, they can renegotiate financing at that time. For a wide range of other reasons, some developers just don’t want to wait.
Despite the various reasons to move forward with construction, commercial mortgage brokers should advise developers to take a hard look at determining whether to commence with a shovel-ready project. Looking forward, the good news is that your clients will likely be able to access better deals on land pricing over the next 12 to 18 months. This, combined with lower costs of materials and labor, is attractive and encouraging, but no one can know for sure what the future may hold.
Everyone is bracing for a potential second wave of COVID-19 along with its short- and long-term effects on the U.S. economy. This is the primary unknown factor the market is dealing with right now. With the first wave of the virus, interest rates went up. No one can predict what the impact will be on the commercial real estate industry — and new construction, specifically — if this crisis stretches into the fall, winter or even into next year. The longer the uncertainly, the longer we will experience increased pricing.
At a certain point, construction financing rates will trend downward once lenders feel more confident and come off the sidelines to put capital to work in this space. Right now, however, the industry is in a wait-and-see mode. Only time will tell how we will emerge from this devastating global event, but a demand for new development remains.
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When the dust has settled, developers will find themselves in a more favorable financial position than before the crisis as land pricing and construction costs decline from all-time highs in many markets. Likewise, mortgage brokers will have more opportunities to successfully close these types of deals. ●