Construction Lending in Today's Changing Marketplace

Wednesday, November 8, 2017

Real Estate Indicators by senior managing director Thomas R. Didio in HFF's New Jersey office. 

In the past, developers of commercial and residential multifamily projects would spend years getting projects through the state and local planning approvals and would have a number of lenders that would be willing to fund a significant portion of the construction and land cost to build to the project. The loan amount could be as much as 80 to 100 percent of the construction costs and land purchase price. There were not many new opportunities coming into the market, so a new construction project usually got quite a bit of interest from the construction lending marketplace.

These transactions were typically funded at aggressive spreads over LIBOR, partial repayment guarantees (15 to 20 percent) and a small origination fee.

Today, we are experiencing a market that has thousands of approved units in all stages of development in several quality locations throughout New Jersey, which has caused many lenders to evaluate their existing construction loan portfolios, and this, in turn, has slowed down the commitment process significantly. For those borrowers that do not have banking relationships and a significant book of business, lenders have been reluctant to fund the requested construction loan. If a potential borrower has a solid banking relationship and is an experienced developer, such borrower will have a much better chance to secure a construction facility in today’s market. However, pricing and terms have changed from 80-100 percent of cost to 60 to 65 percent of cost, which means real cash equity has to go into each new project, usually as the first dollars into the project. Pricing has risen to LIBOR plus 300 to 400 bps, and origination fees have increased to 75 to 100 bps of the loan amount. In addition, repayment guarantees have increased, and many lenders want full personal recourse to fund new construction.

What has this done to the active developers in the market? If a developer is required to infuse each deal with more equity, they either must write larger checks or do fewer projects. The capital markets have addressed this need by creating preferred equity or mezzanine debt options to fund the gap between the 60 to 65 percent senior loan and the 85 to 100 percent loans funded in years past. These subordinate debt positions allow the developer to retain full ownership in the project, and, upon completion of the construction, they can refinance or sell the asset and pay off the mezzanine/preferred equity and the senior lender and retain all the profits. These options are being offered by institutional investors such as private equity funds, REITS and life insurance companies as a way to achieve higher yields than simply funding a senior loan. Typically, the construction mezzanine/preferred equity has a cost of nine to 15 percent, depending on where the debt is situated in the capital stack. These deals are very complicated, as the subordinate lender and senior lender usually want a recognition agreement, which allows the subordinate lender the right to step into the borrower’s portion to finish the project upon a default and allows the subordinate lender to pay the senior lender out. This agreement requires the senior lender to fund a new borrower (the subordinate lender) to finish the job and potentially becomes very problematic if the borrower defaults for both the mezzanine/preferred equity provider and the construction lender.

The bottom line result of the slowdown of the construction lending marketing is:

  1.  pricing and terms have gotten more difficult/expensive;
  2. deal structure has become more complicated within the need for subordinate debt and the associated cost of that debt; and,
  3. the sponsor equity required to fund projects as well as the amount of personal guarantees have risen.

It’s a difficult time to be in the market for a construction loan, but we have been successful finding lenders (banks, life companies, pension funds, etc…) to step up and fund a quality developer with a strong project at reasonable deal terms that allow the project to be built.

About Thomas R. Dido

Thomas R. Didio is a senior managing director in the New Jersey office of HFF with more than 30 years of experience in the commercial real estate finance industry. He is primarily responsible for institutional debt, structured finance and joint venture equity transactions. Mr. Didio has been involved in placing and facilitating debt, structured finance and equity transactions and sales aggregating in excess of $10 billion.  

Mr. Didio was a partner in the commercial mortgage banking firm of Fowler, Goedecke, Ellis & O’Connor, a predecessor of HFF, and was instrumental in opening the New Jersey office in 1994.

Originally published in Real Estate NJ's October issue.

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