Loan Sources: Your Local Bank
Local and regional banks are still one of the only sources for construction financing. Given the struggles many lending institutions have had over the last four years, it can be hit or miss as to whether a specific bank will entertain construction financing. The reason the majority of construction loans are done by regional and local banks is these institutions are best equipped to understand the dynamics of the local real estate market and are comfortable with many of the localized risks associated with construction projects.
A select number of national banks will finance construction loans nationwide, however, they typically work with more experienced developers. Many loans are “relationship” loans, which means a large part of the credit decision to lend is based on the strength of the borrower and his past banking transactions with the lending institution. So, if you have an existing relationship with a current bank, it may be the best place to approach regarding a construction loan. After that, I recommend other local banks in the area. The easiest way to access national and regional banks is through a mortgage banker.
Understanding the Market: The 'Feasibility Study'
The most important part of securing a construction loan is demonstrating a firm understanding of the market to the bank. A bank will want to see a feasibility study addressing the following:
Depth of the market. Based on the demographics of the surrounding area and the growth trends, how much square footage can the market absorb? Is this a first-rate location? Location matters to lenders. You need to prove your location is a sure thing. Currently, infill locations in top-tier markets are the easiest locations to finance.
Absorption. What is the anticipated lease-up rate? How have other construction projects leased up in the competing area, and where did they stabilize? The old idea that you can project 2 percent per month and stabilize the property at 86 percent is no longer true. When seeking a loan, you must go to great lengths to prove the absorption rate.
Pricing. What’s the most likely rent you’ll receive based on the market? How does the rent relate to the construction costs and demographics? If land and construction costs are too high, you’ll need to charge higher rents to justify them. However, are these higher rents supported by the economy in your designated trade area?
Competition. Who are the competitors in your area? What do their properties look like? What are their occupancy levels? The presence of competitors can indicate a need for self-storage properties, but it can also indicate market saturation that can make your business less profitable and turn off lenders.
Construction costs. The lender will want to see an analysis comparing your construction costs to industry averages and other units in the area. In several markets, existing properties are selling below replacement cost; therefore, it may make more sense to acquire as opposed to develop. Your feasibility study will help you determine which option is right for you.
Zoning. It’s important to know the zoning regulations in the area in which you wish to build. Is the parcel properly zoned for self-storage? Zoning restrictions of future development are a major barrier to entry. Being able to quantify barriers will go a long way in getting your loan approved.
Return on investment. Based on the construction costs, anticipated rents, lease-up rates and other factors, what type of return can the investors expect?
All banks require this “feasibility” study, though how the study is performed will vary from institution to institution. Some banks may ask for a third-party feasibility study, while others will accept one generated by the borrower. Many times the bank will accept a borrower-generated feasibility study and rely on the appraisal to verify the claims. Regardless of whether you hire a third party to perform the study or do it yourself, as the borrower, you need to know the feasibility of the project before you seek a loan.