According to the U.S. Census Bureau, the dollar volume invested in new self-storage development in 2017 was more than two and half times that invested during the last peak in 2007. However, unlike construction booms of the past, this new cycle isn’t fueled by lenders loosening their underwriting standards. There are simply a lot of new projects that fit within the necessary guidelines.
However, being that we’re now in the fifth year of the post-recession development cycle, we should expect lenders to evaluate proposed projects and developers with additional scrutiny. If you’re seeking a construction loan, here’s advice on formulating your financing request to ensure success.
When it comes to construction financing, local and regional banks continue to be the most common sources. Local lenders are often better equipped to understand native real estate dynamics than those who aren’t as familiar with the subject market. However, because local banks can have limitations on loan size or aggregate loan limits to one borrower, regional and national banks can be great alternatives for larger or more active borrowers. Also, after building a successful relationship over several transactions, banks are often willing to follow their customer to a broader geographic footprint.
Terms to Expect
For a conventional construction loan, you can likely expect it to be structured at 65 percent to 75 percent loan-to-cost and no more than 70 percent of stabilized value. Most such loans are floating-rate and based on either a Prime or LIBOR Rate. They generally have a three-year initial term with interest-only payments, one or two 12-month extension options, and a 25- or 30-year amortization schedule.
Most construction loans will require completion and personal guarantees for the repayment of principal and interest. There are few lenders that will consider waiving personal guarantees under certain circumstances (typically very-low-leverage loans in top-tier markets), but will still require a completion guarantee from the borrower. Some will allow the recourse/guarantee to “burn down” or reduce at certain occupancy or operating-performance hurdles.
It’s important that every construction budget include an interest reserve sufficient to service the loan during building. This reserve should also cover any operating shortfalls during the initial lease-up period until the property cash flow is at breakeven.
Building the Request
Whether you’re experienced or a first-time developer, when seeking a construction loan, it’s important to understand the information you’ll need to supply. A well-prepared package is important in presenting your request. It’s imperative that it answer all the lender’s questions and make his decision to approve the loan an easy one.
Initially, the lender will look at the financial and operational strength of ownership before he’ll even start evaluating the viability and strength of the project. He’ll focus on the individual(s) who’ll be responsible for project completion as well as management and repayment of the loan. Be ready to provide:
- A biography for all key individuals and principals
- The approximate net worth and liquidity of each proposed guarantor
- A summary of background and experience of key entities and vendors including sponsor/owner, management company, general contractor, architects and engineers, etc.
Next, you need to provide information about the physical aspects of the development, including:
- Site plan
- Floor plans
- Renderings (pretty pictures to help tell the story)
- Municipal approvals, permits and zoning information
- Construction schedule
Finally, there are the financial components that support the construction costs and projected project lease-up. The lender will want to see:
- A schedule of total project costs, including land, soft costs, site work (and off-site work if required) and hard costs
- Land valuation
- Proposed unit mix
- Pro forma operating income and expenses, including the monthly schedule from construction start through completion and occupancy stabilization
- Annual schedule for five years of operation
Evaluating the Market
All this information is great, but doesn’t mean a thing unless the market will support the project. Given the amount of new construction in today’s real estate cycle, it’s more important than ever to understand current supply and any projects in the planning stages. You must show the lender that the local market can support and absorb new supply, and your rent projections and lease-up schedules are viable. A feasibility study from a qualified provider should include the following at a minimum:
- Zoning analysis
- Competition analysis (all competitors within a one-, three- and five-mile radius, addressing geographic and demographic patterns, their unit mixes and rental rates)
- Supply-and-demand analysis
- Absorption analysis
- Market pricing (Will the market support pro forma assumptions?)
- Construction costs (projected costs compared to industry averages or standards)
Many “experts” believe the industry’s current expansion cycle will level off this year or next. Even the real estate investment trusts have reported that in some of the Metropolitan Statistical Areas in which they operate, year-over-year revenue is shrinking. Moving forward, expect lenders to take an even closer look at competition when offering terms on new-development loans. Though the process of securing construction financing takes preparation and diligence, following the above guidelines will ensure borrower success on the right project.
Neal Gussis is a principal at CCM Commercial Mortgage, a mortgage-banking firm that secures financing for self-storage owners nationwide. With more than 25 years of experience as a national self-storage mortgage broker and adviser, Neal has secured more than $3 billion of self-storage transactions for operators. For more information, call 224.938.9419; e-mail [email protected]; visit www.ccmcommercialmortgage.com.