Construction projects continue to be one of the more difficult commercial real estate loans to obtain. Requirements have become more stringent and, unfortunately, many of these loans fall apart during the underwriting process.
Add to that the fact that the market is littered with projects that began during the COVID-19 pandemic years but faltered, due either to the increased cost of materials, labor shortages or lenders simply running out of money. Now, these partially finished projects are competing for funds with ambitious new construction loan requests from established developers.
To compete in this marketplace, brokers need to help their clients understand what lenders are looking for and figure out the best way to position borrowers to find success.
Experience and financing
First off, lenders are looking for borrowers with a strong, demonstrable background of success building ground-up projects that are similar in scope and size to the one they are contemplating. For smaller deals, these lenders may require borrowers to have a net worth equal to the loan request, with minimum liquidity of between 10% and 15% of the loan amount. That alone is a tall order that thins out many of the applicants at the outset.
For larger projects — those in the $50 million and above range — banks have typically been the core providers. But money has become scarcer in recent years as perceived risk has risen. Banks that are lending on larger construction projects have become far more discerning, often limiting geographic scope and asset class. Many are now focusing only on multifamily assets.
On average, institutional lenders today are shrinking loan sizes to 65% loan to cost. Banks also are mitigating risk by requiring substantial deposit relationships from developers, tying up cash at a time when it already is challenging to shore up the needed equity contribution.
There is private money available for even the largest construction deals, and for projects outside multifamily. But these markets are especially competitive. To make deals with such lenders, brokers and borrowers need to think like lenders. Better yet, they should think like marketers.
Red flags
Borrowers at this stage have run the logistical gauntlet, from punching down construction budgets to mastering municipal politics. Of course, it’s all very exciting, but that enthusiasm does not factor into the loan analysis. Photos and schematics, market comparisons and walkability scores — it’s all intriguing, but if you truly want to catch a lender’s attention, give them what they want upfront.
What the lender wants to know right out of the gate is where the project is in the development stage. Is it entitled? In other words, has the project been approved by jurisdictions for its intended use? Are the stakeholders committed? Lenders want shovel-ready projects. Otherwise, they are looking at a moving target, and that’s unappealing.
A common red flag is when the stakeholders don’t own the land. The land doesn’t need to be free and clear, and the previous lender can be paid off with the construction loan. But if the purchase is pending, that usually means entitlements will be far in the future and are prospective at best.
The borrower needs to show the stakeholders’ level of commitment. For example, is the borrower coming to the table with an offer for tax abatements from the municipality? Are key tenants cooperating? Who is putting money into the project? Are there contracts?
Likewise, if a borrower can show committed presales or preleasing with deposits in place, it is sure to garner the interest of lenders. The “build it and they will come” approach does not put the sponsor in the best position with regards to other developers competing for the same funds.
Demonstrated history
The borrower will be required to show a demonstrated history of building projects that are commensurate with the loan request being presented. Those who lack experience in any area of the building process can only clear this hurdle by partnering with someone who does. An expert must be in place for each facet of the project.
The proposal must highlight the expertise coming to the table. These resumes must include a list of completed projects for all stakeholders — general contractor, architect, key investors and commercial partners.
Go into detail about the specific, relevant experience of each team member and how it applies to the project at hand. The lender must be convinced that the team can complete the project with ease.
Calculation checklist
There’s a lot of math that goes into construction loans, but, for the sake of perspective, it all comes down to figuring out how the lender is going to get paid back. Even private money lenders tend to look to agency loan parameters as a guide.
This begins with stabilization, which is when the property is fully occupied and income-producing. Typically, the construction loan payoff can be no more than 65% of the stabilized value. This is a very quick calculation that tells a big story. A secret that the lender may be keeping from you is that your method of predicting stabilized value is a test.
To get to a legitimate figure, the borrower needs to project both net operating income and a capitalization rate substantiated by market rents, occupancy rates, operating expenses, property condition and so on. If the borrower tries to reverse engineer those numbers, working backwards based on lender parameters, that’s going to come out, and that will damage the sponsor’s credibility. So, show your math.
“Lenders are rich in construction loan requests today. None of them need to fund your project. However, they may want to if you market it successfully.”
The next stop on the calculation checklist is the predicted debt service coverage ratio (DSCR) the project will deliver at completion. For example, in determining DSCR, lenders may apply a 25- to 30-year amortization at 5.5% rate and a 35% expense load minimum. A DSCR of 1.5 is ideal, where some lenders will go down to 1.3.
Bargaining power
A lender may look at the debt yield at loan exit. To derive that figure, divide the net operating income by the loan amount and multiply by 100. A 10 or above is ideal.
On the front end, a lender will limit the loan amount based on the cost of the project. In today’s market, a reasonable borrower request is below 75% loan to cost (LTC). The borrower will need to make up the remainder through equity.
Calculating credible numbers also works in the borrower’s favor for other reasons. It allows for flexibility. If the DSCR is coming up short, the lender still may offer to fund the project, only at a lower loan amount.
The borrower can get to work on boosting equity through limited partners, preferred equity or mezzanine loans and still profit from the project. On the other hand, strong numbers give the borrower bargaining power when negotiating with the lender. A few lenders may be willing to increase the loan, if the project supports it.
Key components
Lenders are rich in construction loan requests today. None of them need to fund your project. However, they may want to if you market it successfully. To do that, provide the lender with the key components they need to evaluate the loan request.
If you have a shovel-ready project, solid expertise, committed stakeholders, buy-in from the city, and your presentation begins with demographics, you are burying the lead. If you have preleases or presales with deposits, then get that in front of the lender.
Detail the specific expertise of your stakeholders. If you’ve got solid numbers — construction budget, stabilized value, gross and net operating income — that will produce attractive financials, use that to grab the lender’s attention.
“Don’t make the mistake of thinking you can talk lenders into changing their parameters. If the loan request is not fundable as is, fix it.”
And if you don’t meet these requirements, don’t make the mistake of thinking you can talk lenders into changing their parameters. If the loan request is not fundable as is, fix it.
If the borrower doesn’t have the requisite construction experience, that’s easy to solve by partnering with someone who does. If the LTC will not work, bring in equity investors or limited partners at the outset so you are putting your best foot forward before that initial presentation to the lender. The goal is to move to the top of the stack right out of the gate.
No scavenger hunts
Most proposals lenders see are in a similar format and follow industry standard accounting methods. Sometimes the loan request submission is informal, simply a series of pertinent documents. All that is fine.
But as a practical matter, if you want to be an effective marketer, keep it simple. Even on a good day, construction loan transactions are complex. Avoid making your loan request into a scavenger hunt. A good marketer makes it easy to say yes.
Recently, a lender completed an initial review of a large construction proposal which came back to the company owner with the notation “The sponsor is so organized we want to throw them a parade!” When you are getting ready to present your next construction loan proposal, keep in mind that this is the type of borrower that you are competing against.
