How Construction Financing Remains Resilient Despite Rate Hikes
Other areas of debt may wobble, but a confluence of trends continues to prop up lending to the right construction projects
Good luck getting anyone to lend you money to buy a property.
Building one? That’s another story.
Despite endless bad news — commercial real estate debt originations are down 52 percent, while the current market has 32 percent fewer lenders than it did at this time in 2022, according to a second quarter capital markets report from Newmark (NMRK) — there’s one segment of the CRE market that’s seen a steady flow of capital, and deal closings, this past year: construction.
“It’s funny, there’s definitely more liquidity in construction lending than the market realizes,” said Geoff Goldstein, managing director of JLL (JLL) Capital Markets.
It might seem counterintuitive that given the many risks associated with construction lending — primarily the need to build the project in the first place — that this type of CRE financing would be popular in a market beset by lower liquidity, threatening inflation and high interest rates. But these factors have largely played into the hands of construction lenders, who are charging higher interest against the Secured Overnight Financing Rate (SOFR), receiving increased equity positions from sponsors, and seeing more attractive spreads when it comes to the debt yields and debt service coverage associated with underwriting construction loans.
Moreover, lenders recognize that it might take them 12 to 18 months to build a project, and by that time interest rates are likely to be lower, while demand for new buildings in most asset classes should remain in the stratosphere.
“Financing could sort of be taken for granted 24 months ago. There was tons of lending going on, you had lots of options, and it was really about ‘What’s the rate I’m going to get?’ ” explained Doug Faron, managing partner at Shoreham Capital, a West Palm Beach real estate development and investment firm. “Today the question is: Can you line up the appropriate lending partner for your project that works within the underwriting that you’ve done?”
Others concede that while there’s not a lot of lending activity when SOFR is 5.3 percent compared to less than 2.3 percent a year ago, construction financing is available for those seasoned players who have remained in the game and are willing to risk today’s capital for tomorrow’s returns.
“We’re probably getting 20 construction loan requests a week,” said Vicky Schiff, CEO of Avrio Management, a Denver-based real estate credit firm. “It tells me that some of the better borrowers are still looking for construction debt.”
Even though the Newmark data determined that 2023 construction lending is down 54 percent compared to levels from 2017 through 2019 totals, there remains an appetite to originate this financing due to the favorable terms lenders are quoting desperate sponsors, as construction loans have largely filled the void of bridge loans, and value-add deals have declined.
The current period is also presenting a window of opportunity for lenders to upgrade the quality of their loan portfolios.
“Our basis is improving, there’s more equity ahead of us, so we can go up in sponsor quality and down in leverage,” explained Eric Cohen, managing director at Affinius Capital.
The proof is in the pudding.
Affinius Capital is coming off more than $3.5 billion in construction loan closings in 2022, where the average loan size hovered around $150 million, according to the firm. Already in 2023, Affinius has closed $110 million in construction financing for a 193-unit, mixed-use building in Gowanus, Brooklyn, and a $180 million construction loan for a 1.7 million-square-foot, ground-up logistics center in Pennsville Township, N.J.
“On the flip side, the exact reason it’s attractive for us is why it’s difficult for equity: There’s definitely a sticker shock at the cost of capital for construction lending and the lack of funding available,” continued Cohen. “The loans are lower leverage, coupons are higher, which makes it difficult for a lot of deals to pencil from an equity perspective today.”
That equity conundrum has blended with a broader lending retrenchment to create a CRE landscape characterized by confusion and uncertainty.
“Construction lending is probably up as a percentage of total lending, but the transaction volume is down significantly from last year,” said Shoreham Capital’s Faron. “There’s just less entrants in the market, less banks are participating in all types of lending, and it’s that lack of players in the space that are creating problems with the pricing and availability issues we’re seeing today.”
There have been $209 billion worth of construction loans issued in the first half of 2023, compared to $150 billion worth of refinances and $38 billion worth of acquisition loans for investment sales; by comparison, the first half of 2022 saw $421 billion worth of construction loans issued, according to Newmark.
But, if sponsors are being asked to pony up more equity and lenders have largely evaporated from the playing field amid a large-scale liquidity crunch, why have construction loans proven to be the one resilient force within this origination pullback?
“As a firm, we’re a large construction lender, and we’re closing construction loans pretty regularly even in today’s environment,” explained Jonathan Roth, managing partner and co-founder of 3650 REIT, a CRE lending and loan servicing firm. “But the loans we are closing, there is typically a story behind them.”
Historically, that story could be the need for mid-construction financing arising out of an existing lender abruptly ceasing to fund its obligations, or this chronicle could involve a borrower commencing the construction of a building without a loan, having mistakenly believed one would be available later on, and subsequently needing a financing partner to save the day.
So the story of the capital behind construction today, and the projects created by these debt and equity stacks, is a largely misunderstood narrative. It involves risk and third parties, and features paradoxical market assumptions mixed together with metamorphic lending positions.
In short: It’s a mystery inside an enigma demanding a solution.
“That’s the beauty of a market like this,” said Bill Fishel, executive vice chair at Newmark. “You have to go back and ask yourself questions about every constituent-input assumption.”
After all, you know what they say when you assume something.
Risk versus reward
One of the main reasons construction lending seems so relentlessly persistent in this period of market volatility is, perversely, because of the myriad risks associated with the practice.
“The reason construction loans are considered risky is the construction part of it,” said Seth Weissman, founder and president of Urban Standard Capital, a real estate private equity firm. “You’re stepping into a less stable project and you have to finish it.
“A lot of lenders don’t do it, period,” he added.
Essentially, do or die for the borrower.
Construction lenders are inextricably linked to the fortunes of the developer tasked with completing the building, otherwise their collateral is sitting in an unfinished edifice that is worth significantly less than the initial investment. Lenders allocate monthly draws to fund the work and hire third-party consultants to visit the site, often prepared to hear the worst in terms of delays and structural problems.
If that’s not enough, lenders usually commit the entire loan amount on day one, but they don’t get interest payments for most of their calls. So they need to inherently charge more money on the back end as long as the project is finished on time and under budget.
And that’s before the loan potentially falls out of balance.
“The discussion between lenders and borrowers about being out of balance is a conversation — it’s usually not black and white — but in today’s environment lenders are oftentimes using that as an initial reason not to fund,” explained Roth.
Prior to closing a construction loan, a detailed budget is established where the combined loan proceeds and the borrower’s equity are sufficient to complete the project and carry it through stabilization (the period prior to lease-up). If during the course of construction there are cost overruns, or it takes longer than expected to complete due to events like stop-work orders, and the interest reserve isn’t sufficient to carry the asset through stabilization, lenders have the right to call borrowers and say the loan is out of balance and an equity check is required to put it back in balance.
“The lender will typically prevail in this conversation,” said Roth. “But, when you peel the layers back, at least on the transactions we have seen, it’s very difficult to see where there isn’t something else going on behind the scenes.”
This brings in the relationship element, as well as the range of homework that must go into the many choices that determine the fortunes of this shotgun marriage between lender and sponsor.
“Who your counterparty is is very important, and that includes development experience,” said Josh Zegen, co-founder of Madison Realty Capital, a real estate private equity firm. Zegen has a comprehensive view of that intricacy, with his firm both a construction lender and an owner of real estate.
Digging down further, the lender and sponsor must agree on the other key player in the process to take a project across the finish line.
Choosing a general contractor — and discovering which projects that contractor has recently delivered and still needs to complete — are among the main points that any lender-
sponsor group must identify at the early stages of a deal. Others include qualifying the general contractor and subcontractor’s experience levels, assessing the site conditions, and learning the landscape of the chosen municipality in terms of underwriting and zoning regulations.
“There’s so much value creation because every dollar used in construction can yield a dollar and half in value,” explained Zegen. “But there’s more execution risk. However, once a building is built there’s more margin, and it can be less risky from a basis standpoint when lending is executed with depth and experience.”
Others argue that construction lending is safer than loaning on adaptive projects or conversions.
“We think there’s more of a perceived risk to construction loans than actual risk,” said Affinius’ Cohen. “We see more risk in adaptation and heavy re-use, when you’re opening walls and don’t know what’s behind them.”
Despite the rosy eyeglasses worn by some lenders, there are a bevy of inherent risks in this type of CRE financing. First, there is the pressure, and need, to build a project on time, a promise which was dramatically undermined during the COVID-19 era, when construction sites were shut down for weeks (if not months), and workers routinely became ill from a once-in-a-century pandemic.
“During COVID, there were cost overruns, supply chain issues, and the interest keeps billing even if things don’t come in on time,” explained JLL’s Goldstein. “That’s the ultimate killer for a developer.”
Then there are market risks of building a project using the interest rates and economic assumptions from yesterday and leasing it up under the interest rates and market conditions of tomorrow.
“In the last, say, three to five years, where construction costs have moved very quickly, you start off the project in 2018 or 2019, and you think it will cost $400 per square foot to build, but you layer in supply chain issues and the cost of goods, and it costs you $600 per foot,” said Weissman. “It’s a new world. The profit margin has been eviscerated.”
So why — in this brave new world — would any reasonable lender ever accept the risk of construction financing?
Credit is a lot like war: When conditions change — especially for the worse — someone is still sitting pretty.
Multiple CRE professionals emphasized that one of the biggest shifts that has occurred over the last 12 to 24 months in construction lending is the noticeable decrease in loan-to-value (LTV) ratios in a lender’s advance rate. The higher the LTV, the more skin in the game a lender has, as the sponsor is contributing less equity.
This trend of lower LTVs began with the collapse of Silicon Valley Bank (SIVBQ), Signature Bank (SBNY) and First Republic Bank (FRCB) in the spring — a capital markets shock that turned a tepid lending system into a frozen tundra of caution.
“In terms of the pullback in leverage, that was driven by interest rate pressures that ultimately resulted in some of the bank failures, and that’s when we started to see a real focus on stabilized debt-service coverage constraints,” explained Jeff Black, executive vice president of U.S. capital markets analysis at Colliers (CIGI).
The first metric to study here is debt-service coverage ratios (DSCR): an entity’s cash flow relative to its debt obligations. This number helps lenders determine how much debt a sponsor can take when beginning a construction project. When DSCR trends higher, a lender’s LTV exposure drops.
Banks today are underwriting DSCR at 1.15 to 1.3 debt coverage caste, according to Black, which has resulted in a “pretty significant pullback in achievable senior leverage,” bringing an LTV ratio that was typically 65 percent lender debt down to the 50 to 55 percent range.
This is a far cry from the 75 percent LTV ratios that many banks and debt funds were marking on CRE deals prior to the Federal Reserve’s interest rate hikes beginning in March 2022, according to David Perlman, managing director of Thorofare Capital.
The next metric to study is SOFR, which stands at 5.3 percent today. Most construction loans reference the one-month term of SOFR. So a spread of 300 basis points over SOFR is 3 percent above this standard rate (8.3 percent), while a spread of 500 basis points is 5 percent over (10.3 percent). These higher rates translate into more money for the lender, but less likelihood of a sponsor coming to the table.
“Banks can do pricing 350 to 500 (basis points) over SOFR, going from construction loan to permanent loan all in one, as lots of banks want to do the whole project, so they incentivize the sponsor to do it with them as a one-stop shop,” explained Perlman. “Debt funds are usually 500 over SOFR, usually nonrecourse, depending on leverage, the sponsor, and the project. If you want to get higher in the cap stack, you layer in more subordinate debt.”
The final metric to take into account here is the debt yield, which measures the potential return on the investment of a CRE loan.
By dividing the net operating income (NOI) by the loan amount, lenders can forecast their expected payoff upon completion. All things being equal, in a world where sponsors are expected to provide more equity, if the NOI remains steady and the loan amount decreases, that debt yield will be substantially higher today than in previous years.
In 2021 and 2022, construction loans were getting done at a 7 percent or an 8 percent debt yield, explained Goldstein, but that is not the debt yield pattern of 2023.
“Now it gets done at 9 or at 10 (percent), which means there’s more equity in the deals, so the LTV is down, and the lender has more downside protection,” Goldstein said. “They’re getting the same pricing, but at a better basis.”
All this has translated into an increased appetite for construction lending on the part of the more adventurous lenders, even amid constrained capital markets conditions.
“One of the reasons why we like the opportunity is we’re able to come in and lend at a lower leverage point, which requires more sponsor equity ahead of us, and we can generate the same if not better returns than we could generate 12 to 24 months ago,” explained Cohen.
There’s also an appetite among lenders to enter into projects that are half-finished, or have been abandoned by either the lender or sponsor “midstream.”
“We’re getting inquiries asking us, ‘Are you comfortable stepping in mid-construction?’ and we’re happy to engage, as we have a whole development arm, we have the human capital to go in and do the forensic analysis of what has been built and what is left to construct,” said Roth. “It simply requires a higher level of due diligence and scrutiny to ensure that what has been built has been done so appropriately. That risk can be quantified and mitigated by doing the deep forensic analysis.”
This riskier approach to construction lending was echoed by Madison Realty Capital’s Zegen, who said that in some cases he is seeing lenders, like banks, that simply aren’t funding borrowers’ projects because they’re out of balance and need to syndicate new capital.
“Clearly they need to get it done,” he said. “It’s not about the cost of debt, it’s about getting it over the finish line — built, complete, sold.”
Brave new world (of banking)
Historically speaking, banks were built to do construction lending: They’d originate loans, administer draws, and carry on multiyear relationships with dependable counterparties, some known at a local level.
But that was before the second-, third- and fourth-largest bank failures in U.S. history this spring. Since then, an increased focus on the cost of capital has combined with both a renewed concern about deposit levels and the nature of long-term counterparty risk to turn tepid regional bank lending into a full-on retreat.
“Banks have stepped out of the fray since the spring, and we haven’t seen them come back in any meaningful way,” said Shlomi Ronen, managing principal and founder of Dekel Capital, a real estate merchant bank. “Here and there you hear about someone getting bank construction financing, but it’s really far from the norm today, though it used to be the norm.”
To the extent that construction financing exists today from banks on a nonrecourse basis, leverage is being granted in the mid-40 to low 50 percent cost of the loan, while to reach 60 to 70 percent sponsors are tapping debt funds, which hold that capacity within their lending platform, Ronen explained.
“What’s really constraining things right now is costs are relatively high and the economics of most projects are flat to deteriorating, depending on where expenses are shaking out,” he added.
Debt funds have continued to grow and play a more dominant role in this lending space for two reasons, according to JLL’s Goldstein. One, they can hold larger positions — $200 million to $400 million nonrecourse construction holds aren’t an issue for them, whereas most banks want partial recourse and a principal guarantee on the loan. Two, debt funds are willing to lend nonrecourse up higher on the LTV scale because they stand to make greater returns by marking their loan at considerably more basis points above SOFR than a bank would.
“So the debt funds will go higher up on the leverage sale, but they want to be paid for the risk,” Goldstein said. “Some of our clients are attracted to nonrecourse financing, and they’re willing to pay up for it.”
Another reason why debt funds have swooped into the construction lending space is because during the 15-year run of sub-2 percent interest rates and quantitative easing, they had been cut out of many loans. Basically, it was hard for specialty credit lenders to be active on assets in product spaces where they couldn’t compete, according to Newmark’s Fishel.
“It was difficult for some specialty credit lenders to materially deploy into multifamily and industrial because there was so much liquidity and other capital available, predominantly from the banks,” said Fishel. “So that’s the constituent that’s pulled back, and it’s created room for more active participation by those debt funds in sheds and beds.”
Perhaps no deal this summer better reflected the changing landscape of CRE construction lending than the decision by PacWest Bancorp of Los Angeles to sell a $2.6 billion portfolio of 74 construction loans to Kennedy Wilson Holdings, a Beverly Hills-based real estate investment firm. The deal propelled Kennedy Wilson into the world of construction lending.
“It was a rare win for everyone. It was a win for PacWest, as it fit within their strategic goals, and it was a win for Kennedy Wilson, in that they acquired a bulletproof portfolio at a relatively small discount,” said Pat Crandall, senior managing director of Kennedy Wilson, who worked on the deal.
Crandall noted that the portfolio Kennedy Wilson acquired was 65 percent multifamily, with zero exposure to office. “It was met with a favorable review on the part of Kennedy Wilson and their investors,” he added.
It remains to be seen whether many of the construction loans issued today will generate the same favorable reviews (and outcomes) six to 12 months down the line.
Sponsors might be champing at the bit to build for the next 18 months with the expectation that delivery will occur in a market of lower interest rates, higher demand and declining supply, but just to build in this capital market is still a risky proposition — even for the best of them.
“If you think a construction project will go exactly as planned, then you’re in the wrong business,” 3650 REIT’s Roth cautioned. “One of life’s great truisms is that construction never goes as planned.”
Brian Pascus can be reached at email@example.com.