(And some helpful advice from a top capital markets advisor)
Everyone on your team is certain your project is a winner, but it’s a non-starter unless you can get a construction loan.
Commercial banks long have been the primary source of construction lending to the commercial development sector, but tighter regulation since the Great Recession of 2008 means that commercial bankers these days are far more cautious about financing new office buildings, retail centers, warehouses and other commercial real estate.
Borrowers who once expected to get a construction loan covering 75 percent to 80 percent of the building cost at an interest rate of 3 percent now find that banks are willing to finance only 60 to 65 percent at the going interest rate of about 3.5 to 4 percent, and lenders are highly risk-averse.
Lots of folks, in other words, are getting a nasty surprise when they visit their commercial banker to get a construction loan. While there probably are as many reasons that construction loans get rejected as there are potential borrowers, here are five common pitfalls:
How certain are we that the completion of the project will lead to the sale or stabilized lease-up of the project? The answer demands a hard-nosed analysis of the market and realistic thinking about the project’s positioning in the market. It’s an old cliché that hope is not a strategy, but it’s worth remembering. Bank lenders really don’t want to hear about hope.
A cash reserve equal to 10 percent of the project cost long has been the standard. It still is. A borrower who can’t show sufficient reserves — in cash or cash equivalents — to deal with inevitable financial surprises will have a tougher time getting a conventionally priced construction-loan.
This problem is especially common during times where the cost of capital is increasing yet the land price was set at a time when the cost of capital was less. When the project sponsor gets in at a cost that’s too high — paying too much, for instance, for the land in a retail project the proforma gets tight. Assuming that lenders and equity partners in the transaction demand a yield-to-cost of at least 200 basis points, borrowers who paid too much to get into a project often push the pro-forma right up the edge of reasonable expectations. Sometimes beyond reasonable expectations. If the pro-forma assumes perfect execution, commercial lenders are unlikely to go along.
Even well-experienced teams may encounter this roadblock as they move into new product types — the successful multi-family sponsor who steps into retail development, for instance. The answer: Surround yourself with rock stars — the very best, most experienced professional team possible – top architects and contractors are a plus. It’s also critical that you write ironclad contracts that ensure they’ll complete the work. Financially strong equity partners also provide assurance to construction lenders that the work will be completed.
The basics of a package always must be there — a good market analysis, a realistic budget, a detailed take-out strategy, detailed financial statements from the sponsors, good background on the borrowers. But in today’s environment, relationships are critical and help create the fairy dust that separates the proposals that get funded from those that languish. Commercial lending is not a cookie-cutter business. Every transaction is different. A skilled, experienced capital-markets advisory firm will have worked with dozens — perhaps even hundreds — of lenders around the globe on a multitude of different types of transactions. An advisor will help a borrower shape a construction loan package to meet the needs of today’s market, and an experienced advisor has developed the relationships that make transactions happen.