In today's world, what used to be a civilized search for a construction or permanent lender has turned into a frantic nightmare of trying to figure out who's got the money and how to get your project financed.
Owners of good projects with solid sponsors must come to grips with the new reality of underwriting: Lenders no longer underwrite high-leverage loan-to-value or loan-to-cost transactions. The new rule of the day is greater equity, better sponsorship and a lot more skin in the game.
To request financing today, borrowers must be better prepared than ever before. If you’re seeking new construction financing, you’re well advised to hire a professional company to provide you with a feasibility study for your project. Lenders are not only interested in the existing product in the market place, but the potential for other players who may come into the market and have an adverse impact on your proposed site.
Economic Climate and the Federal Reserve
One of the major issues we’re facing in the current economic climate is the capital ratios being required of lenders by regulators. The FDIC wants all lenders to boost their ratios, and there’s a direct correlation between increasing ratios and reducing assets (loans). Banks are being told to raise capital. This will be achieved by selling new shares of stock or selling loans in the open market.
When you look at assistance from the federal government, consider the position of the Federal Reserve Board and its actions. We have the Troubled Asset Relief Program (TARP), through which we have seen hundreds of billions of dollars handed out to Wall Street and the major U.S. banks, ostensibly for the purpose of stabilizing the banks’ financial footing. The banks that have received TARP capital have written off billions of dollars of loans and stabilized balance sheets, but have not funded the loan request for borrowers on Main Street.
In addition, we have the Term Asset-Backed Securities Loan Facility (TALF), which was intended to spur lending to small businesses and consumers at lower rates. To date, there has been very little use of TALF. The program has a capacity of $1 trillion, and was extended until June 30, 2010, to support newly issued commercial mortgage-backed securities (CMBS) lending. The Federal Reserve believes TALF will have a positive impact on the lending market. However, due to the time it takes to assemble a CMBS package, this will only work for large players with portfolios that can be refinanced through major banks or on Wall Street.
Who Has the Money?
So, who has the money, and how do you get your project financed? Banks have severely cut back on their new construction lending because of problems with their residential-loan portfolios. Banks that were heavily involved in residential lending will probably be out of the real estate construction-lending market until 2010 or 2011. These lenders will need to rebuild their balance sheets before they can take on new loans.
There’s concern in the commercial real estate market about overbuilt properties in the office and retail sectors, as well as multi-family properties that have increased vacancies and deteriorated rental rates. These issues cause the regulators a great deal of concern about the stability of the banking industry’s loan portfolio. This consequently affects the percentage of real estate assets banks will have to write off, which reduces their capital and ability to make loans.
Nationally and state chartered banks have different capital ratios they can lend against for secured real estate properties. If your bank doesn’t have the ability to lend you all the money for your property, it can participate your loan with another bank. The problem with loan participations is they essentially ask another lender to approve your transaction, which is difficult at best and impossible at worst.
Regardless of whether you seek a construction or permanent loan, ask your proposed lender if it has the ability to approve and fund your loan without participation with another lender. If it can, submit your request. If not, keep looking.
The ideal lender is a mid-size or regional bank that is familiar with your market and did not suffer extensive exposure to high-leverage construction loans or subprime mortgage lending.
Construction financing is difficult to obtain and requires equity of approximately 30 percent to 35 percent of the total project cost. Depending on the market, project cash flow, and the vacancy rates of competing projects, you may encounter a greater equity requirement for new projects.
The lenders in today's market are looking for debt-coverage ratios of at least 1.25:1. Capitalization rates, which are being dictated by the banks and life-insurance companies, are sometimes as much as 1 percent higher than similar projects that have been used in your appraisal.
The appraisal is old news. Lenders don’t care about last quarter's cap rates. They’re looking at the future and have serious concerns about property value in today's market. Lenders call this revised underwriting the “Stress Test,” at which point they use higher vacancy factors, cap rates and interest rates to determine the probability of a project being successful.
All of this goes into determining how much money you can actually borrow. The construction lender is principally concerned with how it will get its money back, and will underwrite your loan to fit its comfort level. Lenders want to know you can obtain a permanent mortgage or a mini-perm for your project when the loan comes due. In the words of one lender, “I will not make a construction loan larger than what I would write the permanent loan for any borrower.”
Permanent lending for new projects provides its own set of challenges. Permanent lenders include life-insurance companies, large banks, regional and small banks, credit companies, credit unions, conduit lenders, and even hard-money lenders.
In some cases, the permanent loan will not provide enough money for the borrower to pay off the construction loan, given today's underwriting requirements and reduced property value. The alternative is to pay down the construction loan to the amount offered by the proposed permanent lender, or to obtain a second trust-deed loan or mezzanine financing to get enough money to pay off the construction lender.
Underwriting standards are extremely fluid due to the market’s inefficiency. The best deal in today's market for a well-located prime property is a 5.5 percent, 10-year, fixed-rate loan from a life-insurance company, which means the loan is non-recourse. The underwriting on this loan will be a subjective analysis by the lender using a cap rate probably in the 8 percent to 9 percent range, with a stress test at 150 to 200 basis points over the cap rate to determine the viability of your project and, consequently, the loan amount. With $400 billion of refinance opportunities available in the market annually, you’ll find the best deals being cherry-picked by lenders that have money.
The regional banks and credit unions are probably the best bet for permanent loans. If your project is new, all the lenders are looking for some period of stabilized occupancy. Typically, six months at 90 percent occupancy will be the minimum requirement to qualify a project for a permanent loan.
The regional banks and credit unions typically underwrite at fair market cap rates determined by appraisers. While they might apply some stress test, they’re usually not as severe as the major lenders and life-insurance companies. Banks will look for “relationships.” They want your deposit dollars, which, in today's market, are very valuable. These dollars include not only your project accounts, but other commercial accounts and personal accounts in which you have control.
In many cases, credit unions will be represented by a central company, which will underwrite their transactions to a set of standard guidelines. Once the underwriting is complete, all the credit unions and their group will have an opportunity to buy a participation in your loan. To you, the borrower, this participation is invisible. You only make one payment to the lender who closed your loan, and that payment will then be distributed to the various institutions who’ve participated in it.
These are challenging times in the lending market for any type of transaction. The best professional advice you can get is from those in the arena—loan consultants, CPAs, attorneys and other professional support staff. You can hire better qualified talent in five minutes then you can become in the next five years. Good luck in your quest for capital.
Richard Hill Adams is the chairman and CEO of Laguna Hills, Calif.-based American Realty Capital Advisors Inc., which focuses on self-storage and income-producing properties. He has an extensive history spanning more than 30 years of providing construction loans and equity for real estate projects. To reach him, call 949.455.4100; visit www.arca-money.com.