Construction lending has become increasingly more arduous in 2017. Sure, there were high-profile construction loans like Childrens Investment Fund lending $1.3 billion to HFZ in May for 76 11th Avenue and its lending of $290 million to Ceruzzi/Kuafu for 151 East 86th Street. However, several factors have converged to make it hellacious for run-of-the-mill borrowers to obtain low interest rate financing at moderate leverage.
At first, market participants chalked up the pullback in construction lending to skittishness from banks that the market was potentially repeating its past transgressions of overbuilding. The herd mentality kicked in, too, as no bank wanted to appear overly aggressive or careless. Bank of the Ozarks caught a bit of this heat as one of the few lenders to still do nonrecourse construction loans at relatively full leverage. It responded recently (either coincidentally or through excessive demand) by reducing leverage to 45 percent loan-to-cost. This conservatism has had a ripple effect on the rest of the construction lending market.
Most market participants recall the heyday of the last cycle. In 2004-05, Corus Bank regularly would originate 70 to 75 percent loan-to-value loans on condo construction deals with a modest level of presales. Corus famously crashed and burned when the condo market collapsed in 2008. Maybe lenders are heeding the warning signs of the last implosion, but the current nervousness is clearly more than caution.
Supply-demand factors are also in play as increased construction has caused banks, insurance companies and private lenders to be “full up” on construction loans in their portfolios because of deal volume. At first, banks restricted construction originations to only existing customers, but now, they are requiring “run off” or repayment of existing loans before they consider any construction loans.
New bank regulations are also a factor. The High Volatility Commercial Real Estate (HVCRE) rule instituted in Basel III, for example, has had unintended consequences in the market. I have a client who bought land in Williamsburg 27 years ago for $400,000. Today, that same Brooklyn parcel is worth $30 million. The client wants to borrow the full $25 million necessary to build a 90-unit apartment building. However, HVCRE rules require 15 percent cash equity in the loan regardless of the market value of the land. If the banks adhere to HVCRE, they have to reserve the 150 percent of the loan, making the pricing exponentially higher.
So, who has filled the void of the dearth of construction lending? Hard money lenders. Considering that bank lending rates range from LIBOR plus 250 to 300 basis points while hard money lender rates start at LIBOR plus 700, profitable projects soon become unprofitable.
When the hard money construction loan is in hand, that’s when the fun begins. The “reasonableness” test once applied to clauses in the loan documents, but now the lenders use “belt and suspenders” to protect themselves on every item. For example, on a recent hard money construction loan that we serendipitously closed on a spec condo-retail building, the lender felt it wasn’t enough that the general contractor (GC) was a national firm with a bonded, guaranteed-max contract and bonded subcontractors: The lender also wanted an additional insurance policy protecting it in the event the national GC went bankrupt. What?! Meanwhile, even though the city approved the site with proper hearings, worry stemmed from a frivolous lawsuit regarding a nearby site challenging the city’s zoning laws might cause the city to tear down all buildings with the new zoning (despite the fact that the suit was already thrown out but was on appeal). What?! There are countless other examples showing that hard money lenders can afford to wield their power bordering on guile when they know alternatives are scant.
While I could go on about the void in the market needing an astute lender that can write hundreds of millions of dollars of loans at, say, LIBOR plus 500, we have to deal with the reality. Mezzanine lenders and the aforementioned hard money lenders have gladly filled the gap, but again, this will only work if projects have substantial profit and can afford the extra costs. If a deal had a skinny return to begin with, the project simply won’t get built. That’s painful to the developer but, as somebody who watched his two children being born, not quite as painful as childbirth.
Dan E. Gorczycki is a senior director with Avison Young who specializes in placing debt, equity and joint venture structuring, including construction lending.