Jonathan Lee of George Smith Partners Talks Construction Financing
By Alison Stateman September 17, 2018 11:00 am
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When Southern California native Jonathan Lee joined George Smith Partners (GSP), a leading real estate capital advisement firm in Los Angeles, in 2005, he was a relative newbie to the world of construction financing. Originally, he had set his sights on a job at the U.S. State Department. After graduating from the University of California, Los Angeles in 2001 with a degree in political science, he headed to D.C. where he worked as a foreign service officer at the Foreign Service Institute in Arlington, Va. for two years before tiring of the bureaucracy. He decided to return to the West Coast where he worked for the now-defunct MWH Development from 2003 to 2005 before landing at GSP, where he currently serves as a principal and managing director specializing in construction financing.
Over the course of his career, he has arranged more than $3 billion in arranged debt, preferred equity and joint venture (JV) equity. The 41-year-old—who lives in Westchester, L.A., with his wife, 6-year-old son and 3-year-old daughter—spoke to Commercial Observer about his professional evolution, how GSP weathered the great recession and the issues impacting construction financing today and in particular with his firm’s development in the Golden State.
Commercial Observer: When you returned to the West Coast, you worked for a homebuilder, what drew you to that?
Jonathan Lee: My grandfather was actually a hard money lender so I had some understanding of real estate and, at the time, homebuilding was just a good [career]. There were a lot of shops and I happened to catch fire with one. I left the company in 2005 because [the market] was getting frothy, so I thought I’d go to a safe place in commercial real estate and that lasted for a year-and-a-half and then the world imploded. I got hired [at George Smith Partners] in December of 2005 but then the recession hit and we went from 63 employees to 27.
What was that experience like?
Depressing. It was a tough time because a lot of my peers from different industries, banks, lenders, they got laid off. There was this time where there were a lot of relationships you had in this space that just left. They couldn’t afford to hang on anymore, which was disappointing.
But then, it also cleared out a lot of competition, so coming out of the recession there were a lot of new clients that didn’t have pre-existing relationships and needed help structuring their deals.
When I was working for the homebuilder it was strictly apartments and condos, but it was construction. I knew construction and I made it a point to focus on construction loans when I got to GSP.
Has the appetite for construction lending changed much over the last few years?
Oh yeah, definitely. Coming out of 2008 there were virtually no construction lenders out there. Only a few started to dip their toes back in the market and then three or four banks really stepped up; Wells Fargo (WFC) and BofA [Bank of America (BAC)], then a lot of the regional banks followed suit. People got pretty aggressive with leverage, they were going to 70 or 75 percent. But then in the last couple of years, people—especially in apartment construction— thought we were getting a little too overexposed. So, some banks completely left construction [lending] altogether and other banks would dial it back to 60, 65 percent.
No one had really built condos or for-sale housing in volume. Apartments were very easy to understand and the takeout financing with Fannie [Mae] and Freddie [Mac] has always been there so construction lenders got comfortable with that. But, as some banks got too overexposed in apartments, they either shut down lending or didn’t take on new clients. It forced us to find other banks and other sources of capital.
And when did that happen?
From say ’08 to ’12 there was growth and ’12 to ’14 it sort of plateaued. I think there has been a recalibration between 2015 and today.
When you say it’s been recalibrated, is it now increasing?
Yeah, I think new banks have come in to take the space of banks that have taken themselves out of the market and then new banks, also debt funds are coming in and stepping up leverage so they will go to 80 to 85 percent now.
Who are some of those new lenders?
I don’t want to give names, because that’s kind of our bread and butter, but we say debt funds or equity funds or preferred equity funds are lending money up to 80 and 85 percent behind banks that are lending 60 to 65 percent.
What is driving the lending appetite and new banks coming into this area?
I think they are coming late to the game and they want to take some market share. They see others who have left the space and they see an opportunity there. So now it’s [senior lenders], JV equity, preferred equity and mezzanine [lenders in the space].
What do you attribute that to?
People are more confident in the economy today. They are looking for yield on their money and if you do a preferred equity loan today, you’re getting a really good deal for your exposure. And if you are below replacement costs, you feel pretty comfortable.
How are you finding traditional banks’ appetites? Are they sponsor- or relationship-driven when it comes to construction lending?
They’re looking for experience in sponsorship and the financial wherewithal to get a project completed. But that has a spectrum to it. Some banks will take more risks than others. A Wells Fargo or Comerica’s money is cheaper than some of the regional banks, but they’d be less stringent on the financing requirements.
Are you seeing much interest in ground-up construction lending or investment?
Definitely.
When did you start seeing that?
It started to really ramp up two years ago and I think it’s pretty much hitting its stride right now because some of the debt funds we are talking about can do fixed-rate construction loans. It basically lets borrowers know where the cost of capital is going in the entire process, which is helpful for borrowers, plus they are non-recourse and borrowers really want non-recourse loans. Debt funds or private equity funds are willing to do that.
If you have a higher leverage deal and you go to 85 percent, you want non-recourse because you know the risk is in just completing the project. It’s less risky for borrowers to take non-recourse loans and lenders are willing to extend non-recourse because they are getting higher yield on their money.
Are there certain types of ground-up construction private equity firms are interested in investing in?
Apartments are still very hot now. Industrial is very hot. I would say for-sale housing, to the extent that it’s available to invest in or to lend on, because we haven’t seen a lot of for-sale development.
Single-family homes just hasn’t come back the way apartments and industrial has. Even hotels are still doing well, but there’s still a little bit of question about how much supply and how many rooms are coming online in certain cities.
What about in the L.A. market. Are there certain projects that people are interested in going forward with?
I think the problem with L.A., when compared to somewhere like New York, is that we don’t have many signature projects, but because L.A. is sprawled out, the bulk of the development is really infill. When you look at the number of units coming on, it’s 25 to 100 unit deals that are changing the city, but they are doing it below the radar.
There are big projects like Carmel Partners site in West L.A. and their site over in Culver City, next to the Expo line [Cumulus and Linea]. I think those are the future of L.A. and those are very sexy and are going to do phenomenally well. They are game-changers for the areas they went into. They are right on the rail lines that opened a couple of years ago and they are bringing mass density basically to metro stops and pulling residents into areas that haven’t seen residential living in a long time.
The high cost of housing is a big issue in California.
I’m affiliated with the Union Rescue Mission (URM) downtown and our homeless population has gone up from 12,000 in 2010 to over 50,000 today and if you talk to the leadership at URM, they say the number one reason for homelessness and the increase in homelessness is a lack of affordable housing.
Some people say that one of the causes of a dearth of housing construction is due to Proposition 13, which was passed in 1978. There are measures on the Nov. ballot that may change some of that. What is your take on how those potentially may impact the market?
I think that there is recent legislation coming on two fronts. Costa-Hawkins is a big issue for our industry and I also think the repeal of Prop 13 for commercial properties is also a big issue. I think this state looks at long-term held assets like commercial space as locked equity that they want to tap for the general fund so they see a piggy bank and they want to break it. But it’s going to be a disruption to our space because it will break down values.
Are you getting pushback for higher-price projects?
Yes. Downtown L.A. is going to have a struggle for the next 18 months with new projects because of the supply coming on in that submarket. There’s a lot of apartments coming online so you’ll start to see more concessions but once those projects are absorbed and we know what the price point is for that absorption you’ll start to see new product come back there.
Are you finding that developers can meet their construction deadlines?
No, because there’s a shortage of labor. That’s the other problem.
In L.A., we’re seeing subcontractors sign contracts on multiple projects, but they’re sending skeleton crews to the projects so the work isn’t going as quickly as it could. They are signing say five contracts, but they only have the ability to do three projects fully staffed so all five of those projects are being slowed.
The contractors that have great control over their subs crews aren’t experiencing delays, but overall the labor market is so frothy that guys are being hired away from sites and going to other jobs.
How much of a slowdown is the skilled labor shortage creating?
Projects that should be done to 18 months are dragged out to 3 or 4 months past their scheduled delivery date but also the other big problem we have right now is the city itself. DWP [The Department of Water and Power] is not coming out and hooking up utilities in a timely way.
Are there certain asset types that aren’t being financed right now, that people are staying away from in Southern California?
Real estate is four food groups, residential, industrial, retail and hotel and all four are being financed right now, but there is a softening in retail and there’s a softening in leverage on hotel deals. So instead of 65 percent bank debt, you’ll probably only get 55 percent.
What is it about retail that’s dragging it down?
Retail is an unknown. There is a lot of fear built around retail. The core retail guys are still making retail deals work, but because of land costs it doesn’t justify building a new retail center when you can build a new apartment.
Is that here [in California] or nationally?
I think that’s particularly here. I’ve seen guys buy retail centers and entitle them for apartments.
What about nationally?
Condos are the hottest thing in the world right now, because there’s this pent-up demand for for-sale housing. Nobody is building them because the apartment takeout financing is much more available.
If you are building condos, there’s just a greater risk. Also, you’re treated differently for tax reasons. If you are selling a bulk apartment deal, the tax treatment is less than if you sell individual units because of ordinary income. So, in short, you get penalized financially for selling condos.
It’s tough. In California, we have a lot of legacy laws where if you build a condo and there’s a defect within 10 years you can be sued so it’s safer for a developer to build an apartment building. They’d rather just move on in life rather than worry about something that is going to come back nine years later.
Are trade tariffs putting any upward pressure on real estate prices?
Not the final values, but definitely the cost. We’re starting to see some yield cost go up. The full effect of those hasn’t come in but we could see steel go up 15 percent or more. And then lumber costs have also gone up because of tariffs and demand. We’ve seen lumber prices go up 30 percent year-over-year.
What’s that going to do in terms of the financing landscape?
The only way you can justify those costs is if you pay less for your land or you get more for your rent. So, either the seller of the land is either going to feel it, which isn’t likely, or prices are going to continue to go up.
Are there certain hurdles that they are facing now in terms of getting the financing to get off the ground?
There are two points in the real estate cycle, when there’s lots of deals and no money and when there’s lots of money and no deals. And everything else is a pendulum between the two.
Right now, there’s a lot of money and it’s tough for deals to pencil.
Why is that?
That’s because land costs are up and the cost to build is up, labor and the length of time, especially in California, to entitle.
How much longer does it take to entitle here than in other markets?
We did a 159-unit deal in Boise, Idaho. It took that developer nine months to entitle the site. The same developer, Local Construct, it took him two-and-a-half years on [Perch] a site in L.A., in Eagle Rock.
In gateway cities like Orange County, L.A., Seattle, Portland, San Francisco that pressure is being released into Colorado Springs, Boise, Idaho, and you are seeing a lot of it migrate. Boise is the fastest growing city in the U.S. right, Reno, Nevada is growing. It’s because people are getting out of these cities and they are moving to where they can afford homes. What’s interesting is that businesses are following them because they want their employees to be able to have a comfortable life and have kind of the American Dream.
That’s why Toyota left Torrance [in the South Bay of L.A. County] and went to Dallas. Because they are trying to attract talent from an employee base by giving them a certain lifestyle. We are seeing a small trickle of established companies leave, but if California continues to increase taxes because of [changes to] Prop 13, I think you’re going to see more companies leave.
Moving forward in the next year or so, how do you think the landscape is going to change?
The people that are going to be successful in the next 12 months are going to be the developers and clients that have the best structure in their financing. If they are able to get really cheap debt with high leverage, that kind of takes the risk out of it and they have to raise less equity. I think that’s an opportunity. But as the market continues to progress, the more and more structure is needed to finance those deals.
