Construction, commercial and land financing in today’s climate

By Jeff Levin

Things have gotten noticeably chillier when it comes to bank loans for the construction, commercial real estate and land markets. Developers are suddenly getting the cold shoulder from previously helpful local banks. This change in attitude is a bit curious given strong GDP growth, low unemployment, and only inventory for multifamily is nearing its long-term supply high water mark when considering all the property segments. Meanwhile inventory for other segments, like medical-offices, are only at a fraction of their long-term supply levels. Although the present outlook is rosy, banks are facing increasing regulatory pressures and are concerned about the possible end of the current boom cycle, leading many of them to become much more conservative when it comes to lending. Fortunately, developers can look to other sources of funding, including insurance companies and private “hard-money” asset lenders, to start and/or complete their projects.

WHY ARE BANKERS NERVOUS?

The current expansion, which began after the Great Recession ebbed, is now the fourth longest in U.S. history. The stock market is booming, fueled by corporate profits and expectations of meaningful tax reductions from Washington. The unemployment rate is down to 5 percent in the most recent quarter, according to the Bureau of Labor Statistics.

Bankers’ mentality today brings to mind a famous Shakespeare quote: “There is nothing either good or bad, but thinking makes it so.” Because the current cycle has such positive fundamentals, lenders and their regulators speculate the market cycle has neared or passed its peak and can only trend down from here.

In addition to their concern that the economy may be overheating, lenders face a combination of worrying challenges from regulations as well as nominally higher interest rates. The expectation of continued economic expansion is priced into the stock markets and interest rates, but lenders are being cautioned by regulators to have a downside strategy when it comes to construction, commercial real estate (CRE) and land risks. Let’s examine these in detail from the bank’s perspective.

RISING INTEREST RATE RISK

When interest rates rise, the banks charge more. So, why do banks find the rising rate environment to be risky regarding their borrowers in construction, CRE and land?

First, it’s clear that the U.S. is not facing just a short-term upswing in interest rates due to the Fed temporarily taking its foot off the accelerator of quantitative easing. In fact, this is a seminal change. The Fed has been clear that the historically low interest rate environment is permanently ending. In first quarter 2017, there was greater than a 600 basis point spread (BPS) between the Libor rate and cap rates, and a greater than a 400 BPS spread between the 10-year Treasury notes and cap rates. This meant that borrowers benefited greatly when they had strong project-fueled cash flow that allowed them to earn back their initial capital and pay a return to their equity investors. But more recently, the rising interest rate on floating rate loans will take a bigger bite out of borrowers’ cash flow, naturally resulting in lower debt service coverage. If the interest rate is fixed, then when borrowers refinance a project, they will likely not receive either the same free cash flow or a similar level of loan proceeds as was available to them during the previous low interest rate cycle.

Simply put, higher borrowing rates will result in fewer loan dollars, assuming that advance rates hold steady. As a result, borrowers will need to increase their rental rates and more tightly manage their operating expenses to generate enough cash flow to ultimately support refinancing the note. Naturally this provokes some anxiety with the banks.

BANK LENDING IN TODAY’S ENVIRONMENT

Banks are still originating construction loans, but they’re pushing back regarding leverage and insisting that borrowers bring more equity to the table. Of the construction loans banks will originate, for the most part, they are looking to finance longstanding clients who are proven operators with projects in attractive submarkets. The more speculative projects, or ones with newer builders, are not likely to find a home at the local savings and loan or commercial lender. Larger banks and S&Ls are also being forced to be more stringent with the quality of their construction loans due to the new Basel III rules. There is a requirement in Basel III that banks examine and determine whether certain transactions should be classified as high volatility commercial real estate (HVCRE) loans. This rule impacts any bank with more than $0.5 billion in assets, and all savings and loan institutions. Basel III requires the banks to hold an additional 50 percent of cash reserves for loans that fall into this HVCRE category. For example, if a bank did an $8 million loan in the past and had to hold $2 million in reserves against that loan, now if the loan is classified as an HVCRE, then the bank would have to hold $3 million in reserves That, of course, negatively impacts its capital ratio.

Looking at the types of loans banks will do, it’s clear that they have become increasingly picky. Regarding CRE loans, banks prefer to finance projects that offer them the comfort of proven cash flow. Class-B and C properties, particularly buildings with long track records of good operating history, continue to remain fairly desirable for banks as cap rates remain low. But outside of these workhorses, for many commercial deals, banks are hesitating to lend because they want to see how absorption rates in each market will trend.

WHERE TO GO IN THE CURRENT MARKET

Although the banks are pulling back from many segments of construction, CRE and land deals, nontraditional lending sources are filling the gap. Life insurance companies and private lenders are becoming more competitive in this space. Insurance companies are more conservative in selecting projects to finance and generally steer towards larger ones. The benefits the insurance companies offer include prevailing interest rates and enabling a developer to close on permanent financing for the project well before actually breaking ground. The developer does not need to follow the typical two-step borrowing process that they do with banks. Typically, they first receive a construction loan. Then, once construction is complete, they have to refinance it to a different note. With insurance lenders, the borrowers receive permanent financing for the project in a single loan.

Insurance lenders prefer Class A office buildings in strong submarkets, plus shopping centers anchored by supermarket chains that have a strong revenue track record. Insurance companies are much less interested in Class B properties, or areas that aren’t really considered gateway markets because they are more susceptible to economic slumps. If they do hospitality loans at all, it is only for the top-tier hotel chains, and only in major markets.

However, insurance lenders have historically shown that they won’t stretch to win deals, and they won’t lend on anything that doesn’t look like triple A quality. So unless a developer has a top-tier opportunity in a gateway market for a non-multifamily development, the insurance companies are probably not going to be a fruitful lending source.

For everything below that top-shelf type of project, the private lenders (often called “hard money” lenders because of the “hard asset” loan collateral) are a source of funding. Most hard money loans are for commercial projects lasting from a few months to a few years. These lenders don’t face the regulatory hurdles that banks and insurance companies have because the private lending market has always been unregulated by state or federal laws, although some maximum limits on interest rates due to state usury laws can restrict hard money operations in some states like Tennessee and Arkansas. While the regulations put in place after the 2009 banking meltdown require lenders of residential loans to evaluate a borrower’s ability to repay the loan on primary residences (or face big fines for noncompliance), hard money lenders only make commercial loans so that they don’t face the risk of the loan being classified under the Dodd Frank, TILA and HOEPA guidelines.

The primary criteria hard money lenders use is the liquidation value of the collateral that backs the note, not the income potential of the project or creditworthiness of the borrower; therefore, hard money lenders will always want to calculate the Loan to Value (LTV) either by determining the liquidation value of the asset through a broker price option or an independent third-party appraisal. In contrast to a bank offering a 75 percent loan-to-cost construction loan, private lenders might be around 65-70 percent for new construction. However private lenders are known for having greater flexibility than banks, which indicates their decision-making is based on more than just the LTV and the type of asset to be financed. Also taken into consideration is the quality of the developer and management team. Experienced hands—as well as newer borrowers who have done their homework, provide buttoned up projections, and are easy to communicate with—can win support from private lenders for projects that banks would simply turn down. Certainly, the interest rates on hard money loans are higher than the rates for traditional business loans. That’s because the cost of capital for the lenders is significantly higher than what banks pay. Interest rates can range from 10 to 18 percent and higher, so projects with weak earnings potential are unlikely to get much traction. However, private lenders are known for fast turnaround and flexibility. When the banks refuse to finance an otherwise worthy project, the hard money lender may be the right fit to make the deal a reality.

About the Author: Jeffrey N. Levin is the founder and president of Specialty Lending Group
and Pinewood Financial, which together provide a full suite of boutique private real estate lending services in the Greater Washington D.C. area. Before launching SLG, between 1993 and 2007, Levin was a co-founder and CEO of iWantaLowRate.com and a co-founder and president of Monument Mortgage. Levin is a recognized authority, lecturer, panelist and is also a member of the American Association of Private Lender’s Education Advisory Committee. He earned a bachelor’s degree from The American University in Washington D.C. and lives on Capitol Hill with his wife, Dunniela, a Canadian trade lawyer, and his two sons, Jack and Charlie.