Bison Financial Group principal, David Repka, was recently interviewed by a national commercial real estate publication to discuss his views on where the construction lending market is headed in Q4 2021....
Q: What are your predictions for construction lending going forward?
A: Demand for rental housing continues to soar. Developers will build more multifamily rental housing in all of its flavors:
- Luxury / Market Rate
- Age-Restricted Senior Housing
- Assisted Living / Memory Care
- Build-for-Rent Communities and Scattered Lot Rental Homes
The other bright spot remains freestanding Build-to-Suit opportunities for growing national, regional, and local tenants with high credit quality and Covid hardened business models.
Q: What will be the biggest changes/trends in construction lending in the next six to 12 months versus years past?
A: Lenders are vetting Developers/Sponsors more than ever before. They are asking more questions earlier in the process than ever before:
- Has the development team worked together before?
- What has been the size and scope of recent projects?
- Have their most recent projects been sold or refinanced? Or do they still have contingent liabilities on their PFS?
- Who is the General Contractor?
- Is there a GMP in place?
- Have the project costs been bought out?
- Will Sponsor sign full faith and credit recourse? Or is the ask for some sort of non-recourse loan?
- Any skeletons in the closet we need to know about?
Q: How will construction lender underwriting change going forward?
A: We see a barbell shaped market with very high quality opportunities on one side and challenged opportunities on the other side. Best in breed sponsors will continue to attract construction financing from the nation’s largest, lowest cost construction lenders because they are able to answer the critical questions about quality of Sponsorship and are able to capitalize their deals with 35 to 45% equity. Sponsors that do not have 35-45% equity are looking for creative solutions to fill the gap. One of the creative solutions is C-PACE financing. We are starting to see a growing market acceptance of C-PACE financing to provide about half the required equity (e.g. 60% Senior/20% PACE/20% Sponsor Equity). Construction lenders are getting more savvy on how C-PACE plays into the project’s capitalization. C-PACE is looking for a coupon rate of return in the 5.75-6.25% range as opposed to traditional mezz/pref/JV equity seeking 15-25% IRR.
Q: Which properties/projects will lenders target for construction? How has this changed?
A: While there are exceptions to every rule, construction lenders are primarily seeking to lend on multifamily properties and single tenant net leased (STNL) properties. Market rate multifamily, workforce housing, and senior housing are all attracting funding from construction lenders. In the STNL space there has been a realization by a select number of non-bank niche lenders that 100% LTC financing is actually a pretty low risk loan and can command pricing in the high single/low double digits. Lenders in this space require three things to mitigate their risk:
- proof of site control of the property to be developed
- fully executed lease with no outs from a tenant they like
- shovel ready site with all municipal approvals, land use, zoning, entitlements, and permitting with no open issues of any kind
Q: What will be the typical LTC on a construction loan?
A: Setting aside STNL deals that can be funded to 100% LTC, conventional investment properties are being funded at 55-65% senior debt via banks and 65-75% LTC with non-bank lenders. More exotic financial structures utilizing ground leases, mezzanine, preferred equity, and/or C-PACE can push all-in leverage to 80-90% of cost.
Q: What will be the typical construction loan rates?
A: Rates will depend on risk, risk depends on leverage. Pricing for 55-65% LTC senior construction debt via banks is in the L+175 to 300 range with the delta dependent on the experience, NW, and liquidity of the Sponsors. Pricing for 65-75% LTC with non-bank lenders is L+400 to 650 for multifamily and L+750-900 for specialty projects like hotels, for-sale condominiums, and STNL properties at 100% LTC.
Q: How much recourse will construction lenders require?
A: There are four major types of recourse:
- Loss of Interest
- Loss of Principal and
- Bad-Boy Acts.
All lenders will require recourse for Bad Boy acts such as fraud, misrepresentation, and misappropriation of funds. Due to the nature of a construction project lenders will require various levels of recourse for completion of construction/performance. Many times this risk can be shifted to a general contractor with a Guaranteed Maximum Price (GMP) Contract and a bonding package. We are increasingly seeing a requirement to rebalance an interest reserve creep into loan documents on what has been represented as a non-recourse loan.
Q: What will be the typical loan terms?
A: Depending on the size and complexity of the project, the typical construction loan is the period of construction plus an additional year to stabilize, refi, or sell the property with the ability to buy one or two extension options. For fast-moving construction projects on STNL properties, lenders typically require minimum interest for 6 to 9 months.
Q: What specific markets will see the most construction financing activity?
A: Sunbelt (smile states) with strong job creation. Leading the pack will be Florida, Texas, and Arizona.
Q: What markets will construction lenders shy away from? Why?
A: Lenders will continue to monitor job creation. When job creation slows or reverses, it will be difficult to borrow capital for new construction except for STNL build-to-suit properties with strong national, regional or local credit backing.
Q: What will lenders want to see from the borrower/developer? (certain net worth and liquidity, certain number of properties under their belt, etc.)
A: For projects with market risk due to lease-up risk (multifamily, hotels, etc.) Senior lenders will continue to drop leverage until they are comfortable with their basis. 55-65% senior leverage from banks is the new normal. The rule of thumb is that Sponsors need to have a net worth of 1 to 2x the construction loan amount and post-closing liquidity of 10-20% of the loan amount. So there is no ambiguity, if we are requesting a $20 million loan, the Sponsor will need to have a NW of $20 to 40 million with $2 to $4 million in post-closing liquidity. Sponsors that can not meet these guidelines will either not attract financing, will need to pay higher rates to compensate for the risk, or attract another piece of the capital stack via mezz or pref equity.