Featured ExpertOur Perspective 8/ 17/ 2016

Is a drought coming for construction lending?

Developers need to navigate capital markets carefully as lenders tighten purse strings.

California has been enjoying a robust return of development across much of the state. Yet developers are facing new hurdles as it becomes more challenging to obtain construction financing.

Developers have been increasingly busy over the past three years as construction ramped up across all property types. Industrial completions in the Inland Empire alone topped 20 million square feet per year in 2014 and 2015 with another 13.4 million square feet under construction in the first quarter, according to Cushman & Wakefield In addition, REIS tracked over 19,000 apartment completions in San Diego, San Francisco, Los Angeles metro areas last year, with 20,000 units under construction in 2016.

Financing climate change underway
However, the construction financing climate is already underway. More questions are swirling about the maturing stage of the current real estate cycle and banks are facing more regulatory pressure. Higher construction costs are also translating to higher loan amounts. All of those factors are prompting banks to question how much more construction debt they really want to offer at this stage of the market.

For construction borrowers, capital is more expensive and less available. Deals that were done at 200 basis points over LIBOR just nine months ago have climbed to 325 basis points. Guaranty requirements have gone up and loan-to-cost ratios have generally declined to 65 percent, or even lower for borrowers seeking limited or completion-only recourse. The message to the market is that if borrowers want a construction loan in the second half of 2016, they will need to bring more equity and accept more stringent terms.

One apartment developer in Northern California discovered the changing market dynamics the hard way. The firm had construction loan quotes in hand last fall. However, the company decided to wait out El Niño to avoid excavating during the rainy season, and they sat on the offer. The developer came back this spring looking for the same construction loan only to find that market pricing was about 125 basis points higher with a loan-to-cost ratio that had dropped by 5 percent.

The tighter lending environment means borrowers need to shop deals harder to find the best option. Rather than approach three friendly banks, NorthMarq Capital is taking deals out to upwards of a dozen likely lenders in order to find the best competitive deal for clients. Borrowers in California have been fortunate in that they do have a very active financing market compared with some other parts of the country. There is a plethora of California-based banks active in real estate lending, but not all serve the same markets.

In addition, borrowers are being forced to consider non-traditional financing options rather than banks. Life companies will do construction loans on a select basis in cases where they are providing the permanent loan. Debt funds also have been raised to finance construction. However, the cost of that opportunistic capital is expensive, potentially twice the bank or life company rate. This is creating a bifurcated market where borrowers can pursue cheap bank money that is increasingly difficult to access, or they can go with much more expensive fund money that has more favorable terms and is more readily available.

Borrowers who are navigating this current market also need to be prepared for a longer, more arduous process. Covering a broader market can take more time, and borrowers need to understand that quotes are subject to change as loan officers go through their own internal approval process. Banks in particular often have multiple layers of credit approval. Each time a loan goes through a committee approval there is a risk that the terms will be changed as bank credit policies may change. A deal may evolve very differently from what it was originally quoted. In some cases, the outcome may even be terminal. We recommend that borrowers have a back-up source and be prepared to put more equity into the deal.

While banks are more cautious about construction lending in general, they are also keenly focused on limiting exposure in certain property types and geographic markets. In California, as well as nationally, much of what has been developed and is on bank balance sheets is multifamily. That makes banks sensitive to exposure risk in that sector. Some banks are also more hesitant to do office deals. However, at the end of the day, a bank’s appetite for lending differs on a case-by-case basis depending on the existing concentration of construction loans on their balance sheet and the borrower’s credit profile.

What’s a borrower to do?
Although the climate has shifted, obtaining construction financing is not a “doom and gloom” scenario. There remains a robust capital market, but what’s notably different is that not every lender wants to take on more construction risk in the current market. It is important to have a good adviser or mortgage banker to broaden and nurture the market for your loans.

A related question facing the industry is whether the liquidity crunch hitting construction financing will spread to other areas such as long-term loans for refinancing or acquisitions. If that is a concern, then how do borrowers prepare for that shift?

To the extent possible, borrowers may want to get out in front of any potential shift in the market by locking in rates early and financing long-term. Many owners with maturing loans have already done just that, defeasing loans early in order to take advantage of the exceptionally low interest rates. That defeasance has lifted a significant load from the wall of maturities that was set to hit the market in 2016 and 2017 although a sizeable amount of maturing CMBS loans remains.

Improvement in the CMBS market through mid-2016 has helped chip away at that looming wall as the sector has calmed and spreads have narrowed. Banks are also stepping in to fill much of the financing gap, especially as they shy away from riskier construction lending. Opportunistic capital, such as debt funds, offer higher leverage bridge loans with mezzanine available to fill a financial gap.

The upshot is that the U.S. has an active capital market for term loans that is not dominated by any one type of lender. It behooves borrowers to look at a variety of options before they make a choice — be it the loan term from three years to 10 years (or longer), or choosing between fixed or floating rates. Once a borrower has access to and reviews all the options, they can make the best decision for their loan.

This article was originally published in the August 2016 edition of California MBA Magazine.

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