‘Smart Money’ Is Driving Efficiency in Construction Finance Markets
Almost every development project can be financed at some loan-to-cost ratio (LTC) and pricing level. Since the global financial crisis and the implementation of the current banking regulations, “stupid money” has all but disappeared. But aggressive construction financing is alive and well and unlike its predecessors, these aggressive loans are carefully underwritten and priced accordingly. They are “smart money” for the lender and provide an opportunity for the borrower to replace equity with debt at half the price.
Before moving on to aggressive multifamily and condo construction loans, let’s look at the more conservative bank lending models.
Experienced and well-capitalized borrowers can count on local banks to provide well-priced, full, or partial recourse construction loans under $20 million. At CBRE, we recently closed a 75 percent LTC, $15 million multifamily recourse construction loan at 225 basis points over Libor. Terms like those are scarce if the loan exceeds $15 million.
Moving up the ladder, a 65 percent LTC multifamily construction loan in the $20 million to $70 million range will generally price at 250 to 350 bps over Libor. Here is where the major regional and money center banks shine. Again, these are full- or partial-recourse loans.
Construction loans that require only a completion guarantee and “bad guy” carveouts but no repayment guarantee are considered “non-recourse” loans. Only a handful of banks will consider non-recourse debt and these loans are typically 50 percent LTC or less. To increase the capital stack, these loans can be coupled with mezzanine debt in what is known as a classic A/B structure.
Increasing the capital stack requires increasing the mezzanine debt because the senior non-recourse debt typically does not exceed 50 percent LTC. For an all-in capital stack up to 65 percent, construction mezzanine debt works well. However, since mezzanine debt is “first in and last out,” as the blended capital stack exceeds 65 percent LTC, the increased mezzanine component rapidly increases the all-in rate.
However, we’re now dealing with two lenders whose interests are at opposite ends of the risk spectrum. When the going gets tough, the odds that both lenders will cooperate for the good of project are not very encouraging. For this reason, if it’s a close call between an A/B structure and a single-source lender, we typically recommend the single-source lender, even if the cost of capital is slightly higher.
Enter the capital powerhouse opportunity funds who make high-yield construction loans. Funds have been in business for years and represent the best (and sometimes only) way to procure high-leverage debt for projects that do not fit within the typical bank model.
Fund lenders are well capitalized and are willing to take on more risk than conventional lenders, provided they are paid accordingly. The funds are also extremely sophisticated and very creative, and they truly understand the erratic uncertainties of the construction lending business.
Opportunity funds command spreads from 550 to 700 bps over Libor. Typically, 625 bps over Libor is a good middle-ground estimate.
While spreads have dropped from 850 over to 625 over Libor, the base rate itself has increased almost in lockstep. Therefore, the borrowing rate remains about the same, at about 8 percent to 8.25 percent. Typical terms are three years with two additional one-year extension options, a completion guarantee (but not a repayment guarantee), a guaranteed maximum price construction contract, a reputable, bonded contractor, and a borrowing entity with enough net worth and liquidity to handle the unforeseen.
Additional funding for unanticipated events is a common occurence. The fund’s goal is to make a loan, get compensated at a risk-adjusted rate and then get paid off. It’s not looking to take over the project unless it has no other reasonable exit. However, funds are adept at completing half-built projects and have no fear of doing so.
A last word of caution: Higher LTC loans can eat into a project’s profitability very quickly if there are extended delays in completion, leasing or sales. We’ve seen borrowers lose big-time for these reasons alone. But for the most part, higher LTC fund loans have proven to be winners with no equal.
Mark Fisher is a senior vice president at CBRE Capital Markets.