Higher Construction Debt Returns Exist for Eager, Capable Lenders

Today's market has produced greater returns on construction debt, and as a result, many lenders have grown more fond of the “risk” of writing a construction loan and waiting for the leasing market to thaw

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At face value, construction lending in today’s climate could seem like a fool’s errand. The market has shown that is quite the contrary.

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Oversupply and overleverage were the negative highlights of the last downturn. But the longest bull run in commercial real estate’s history was wiped out last March by no fault of the sector itself.

In March, the market swiftly evolved from a borrower’s paradise to a lender’s playground, even though the pandemic and ensuing recession it caused sent many bank and private lenders to the sidelines fearing uncertainty as they worked to shore up their portfolios. Simply being able to underwrite loans, vet borrowers and forecast the market became murkier and riskier, which shifted bargaining power in favor of lenders. Bid-ask spreads between buyers and sellers widened, stalling general transaction activity as hotel and retail assets essentially became taboo.

A pre-pandemic market with too much capital chasing too few opportunities morphed into a market with too few dollars chasing even fewer opportunities. These factors helped to produce an overall more conservative and selective lending environment that put a premium on debt.

As a result, many senior and subordinated lenders jumped to capitalize on the debt repricing exercise that followed. Now, lenders, including regional bank lenders, are eyeing the construction space, where there’s an opportunity to fetch higher returns while being somewhat insulated from the pandemic over the life of the construction, assuming fresh product will be delivered to market two or even three years down the road when — hopefully — COVID-19 will be in the rearview mirror. It’s worth the risk for them, as in many cases, rates on senior debt have climbed to north of 6 or 7 percent and to above 12 or 13 percent for subordinate mezzanine debt.

“When this went down back in March… we began to move our pricing pretty quickly in relation to market forces,” said Brannon Hamblen, president and COO of Little Rock-based Bank OZK’s Real Estate Specialties Group. “The supply of debt and the space we play in quickly changed, and we adapted to that and moved our pricing up anywhere from 75 to 100 basis points at the time.”

Multiple sources who spoke to Commercial Observer pointed to Bank OZK as a “top three lender” for non-recourse construction loans in today’s climate. Even before the pandemic, it had already established its name as an active, yet astute, senior secured construction lender with a rather defensive posture.

Hamblen added that rapid shifts in Libor had a somewhat offsetting impact in repricing efforts, but that the publicly-traded bank has “been around a 5 percent [interest rate], and we have been closing averages north of 5 percent on construction debt. We were no exception there. We capitalized on the state of affairs and moved our pricing and have had pretty good success. Everything can change tomorrow, but we’ve been able to achieve [those spreads at 75 to 100 basis points higher than pre-COVID-19].”

Those who are diving back into construction, benefiting from these higher returns, are senior and subordinate private debt players like Mack Real Estate Credit Strategies, ACORE Capital and Square Mile Capital Management, who have robust asset management operations, alongside other smaller operations such as Trez Forman and Canyon Capital, sources said. Most of today’s interest is focused on multifamily, industrial and life sciences, with some pre-leased or purpose-built offices sprinkled in, according to both lending and advisory sources who spoke to CO.

“There is a lot of cautiousness on development lending because traditionally while you can’t technically default because you’re reserved and funded through the construction period, construction lending is usually considered very high risk because you face an uncertain leasing market into the future,” said Square Mile senior managing director Jeff Fastov, whose group provided a $225 million construction loan in July for Cape Advisors and The Pioneer Group’s ground-up multifamily development at 30-77 Vernon Boulevard in Queens. Fastov said the inherent uncertainty around a future leasing market in typical, pre-COVID construction deals has somewhat been flipped on its head today in that the freezes caused by the pandemic are inevitably going to thaw and a more cautious, restrained construction market should create a brighter leasing outlook.

“We like that dynamic, because despite all the interest in construction lending and in development deals from developers themselves, there’s a lot of caution,” Fastov said. “It’s less liquid, so a lot of projects have been put on hold because they can’t get the funding or the funding is too expensive so a lot of deals are just not feasible. That’s going to further restrict the supply that would otherwise be there [in a normal market].”

That being said, mezzanine providers such as Square Mile, with “real estate skills” and asset management capabilities, per Fastov, are winning more deals, and borrowers and senior lenders have become more keen to involve them. Take Square Mile’s involvement in the mezz debt for a planned multi-story, last-mile logistics construction project at 640 Columbia Street in Red Hook, Brooklyn — the first of its kind on the East Coast — being developed by DH Property Holdings and Goldman Sachs Asset Management.

“We started talking to them about a year ago, and we were going to do a deal all spec, no leasing,” Fastov said. “And then COVID hit and things got reworked.”

J.P. Morgan Chase and Square Mile eventually closed on the $155 million construction debt package on July 20. The building, which the developer broke ground on last summer, has since been leased out, although Fastov wouldn’t disclose who took the space.

“We stuck with the deal and changed terms and we ended up with a leased, built-to-suit building, which is good for us,” Fastov said. “It’s a new physical construction type. The sponsor wanted to know that the lender can understand the collateral and underwrite it and deliver certainty.”

What helped Square Mile was the fact that its equity platform, in partnership with Innovo Property Group, was building a 1 million-square-foot trophy distribution facility at 2505 Bruckner Boulevard in the Bronx — on which Bank OZK provided a $265 million senior construction loan that closed on April 1 — just north of the Red Hook site.

“This is a case in point where we’re developing our own last-mile distribution center in the Bronx, and so [DH Property’s president] Dov [Hertz] and Goldman Sachs knew we had the expertise to underwrite that deal,” Fastov said. “We were only able to do that because we’re in the same business as them, building our very own.”

While these situations aren’t so frequent, they capture the attention of the market.

Smaller regional domestic bank lenders have jumped back into the fray, sources said, but they are sometimes at a competitive disadvantage due to a lack of speed in origination, a historical flaw that’s become more prevalent over the last several years. Even so, bank construction and land development loans have been slowly climbing during the pandemic.

Aside from a small blip at the end of June, construction and land development loan activity from small and large domestically chartered commercial banks has been gradually climbing week to week since March 4, according to recent data ending Aug. 19 that was posted by the Federal Reserve Bank of St. Louis (FRED) via the Board of Governors of the Federal Reserve System.

While the repricing exercise “has moved in our direction,” according to Hamblen, he said that smaller regional players have been able to stand out with a lower cost of debt at a higher leverage point. “We haven’t seen the consistent competition across the country that ultimately I’m sure we will see. Typically, you’re losing out to a different, smaller regional bank. There are still folks that for whatever reason didn’t see the supply and demand equation the same way we did and continue to quote lower pricing than we’re able to go win.”

He added that “there are folks we have been doing business with for a long time and they understand the dynamic, and there’s no hard feelings if ultimately the gap is too wide and they go another direction. Every deal has different equity in it that can shift the playing field with respect to how much value they put into 50 percent leverage.” OZK’s average portfolio LTV and LTC is 49 percent and 42 percent, respectively, Hamblen said.

Despite these positive figures and sentiment, there is no wave of lenders plowing into construction, but there are still gobs of cash sitting on the sidelines.

“We’re finding lender appetite is about as strong as ever,” said Meridian Capital’s James Murad, who operates in the New York area. “Everyone has money and wants to put it out,” he said, adding that lenders are being more “conservative to cover the downside risk. Over the last few months, we’ve continued to see momentum for good bids on quality projects.”

Ironically, running thematically parallel to the U.S.’s currently unpredictable, turbulent political environment, construction lending sentiment seems to ebb and flow week to week, according to other debt and equity advisory sources who spoke to CO.

“It’s day to day,” said Shlomi Ronen, managing principal and founder of Los Angeles-based debt and equity advisory firm Dekel Capital. “You could call one at the beginning of the week and they’re not in [the space] and by the end of the week, they’re back again. It’s because of people’s perception of the future. There’s so much that’s changing outside of real estate, whether it’s government programs that they’re putting into place, the employment situation or rent collections. Everyone is laser-focused on all the data and info that’s out there.”

Moving into the construction lending market to take advantage of the current economic situation, of course, comes with sizable risk, which is why mezz providers like Square Mile stick out as a tool to further mitigate the risks involved today while being able to take advantage of higher returns. But a senior lender’s need for a mezz provider is “totally driven by who holds the junior debt,” Fastov said. “The traditional answer has always been that more equity is better than equity and debt behind you, because there’s more stress behind you.

“We’ve actually gotten proactively solicited by senior lenders to come in behind them, not only to give the sponsor more leverage but also to have strong capable hands between them and the sponsor,” Fastov added.

It seems simple and routine enough, but Fastov referred to it as the “credit support theory” of mezz debt, where you’re getting “two sponsors for the price of one.” And, in some cases, sources who spoke to CO said senior lenders are actually being more assertive in requiring sponsors to go out and find mezz debt before they commit to a loan.

“They want to know who the mezz [provider] is,” Fastov said. Bringing in a mezz player that’s strictly a financial firm essentially just adds to the risk. This is an area in which Square Mile’s lending operation really thrives and has made a name for itself. In today’s climate, it’s an even more attractive proposition.

“Don’t forget, the senior lender is thinking, ‘I don’t want more [debt and equity] behind me. What I need behind me, as a cushion, is what I need.’ Period. End of story,” Fastov said. “Now the question is: Is it a mix of all common equity or is it common equity and junior debt?”

Murad said that the need for a mezz lender really depends on the senior lender in the deal.

“We have a ground-up multifamily development in Queens, and we have a senior bid from a bank and the senior is requiring mezz in the deal,” Murad said. “It’s their first project with the borrower and it will be the biggest project they’ve built. The [senior lender] is comfortable with the basis but wants a mezz lender that’s well-capitalized behind them, someone who can step in and write a check. [So] it really depends on the lender. Some won’t allow mezz at all as a general rule because there would be too many parties involved. It’s a mix… smaller regional banks are less inclined to [have] a multilayered cap stack.”

In the middle market space, demand for mezz from those borrowers has climbed, but not all senior lenders in that space are open to it, given the lack of experienced asset managers.

“There used to be a lot of that stretch first mortgage out there, up to 85 percent, so there wasn’t so much a need for mezz,” said ACRES Capital CEO Mark Fogel. “That’s gone right now, so these middle-market borrowers need that mezz slug that’s usually between 65 to 85 percent, although people doing construction loans are usually capping them at 75 percent of cost. So, lenders are encouraging mezz to come in, but the danger is we’re really reliant on our sponsors to construct the project — that’s who we do our homework on — and I don’t want a mezz lender stepping in when there’s no expertise to take control of the project. I would rather do a stretch first mortgage, if push came to shove, then allow a mezz lender in.” 

Fogel, whose firm just recently made a timely acquisition of the management division of mortgage REIT Exantas Capital Corp., which has bulked them up and given them a vehicle to help stabilize deals out of construction — hopefully with societal issues from COVID-19 mostly history — said that generally “we’re seeing a lot of activity in the multifamily sector for construction loans and rates are being compressed everyday because there are so many players coming into the space. What was potentially a spread that got you to 10 percent before for multifamily is probably down to close to 7.5 now, at lower leverage points than pre-COVID. We were going up to 80 and 85 percent before, and I think most people are now sticking to 70 to 75 percent, but it’s starting to climb up again.”

While activity is concentrated in good markets, Fogel said his firm is concerned about the amount of interest in multifamily construction today from non-local players, pointing to a possible absorption issue that might arise post-COVID due to some overbuilding in certain markets already.

“Those issues are going to rise to the top over the course of the next few years,” Fogel said. “People are building in the right markets, so it’s just going to be an absorption issue more than anything. But multifamily is very quick to recover in that regard. I worry that with so many groups coming in, that might create an oversupply, with equity and debt both just kicking the can down the road as opposed to working with assets that exist today.”