Q&A: Construction Loans, Where Are We Now?

8-3-2017

Barry Slatt Mortgage Company CEO, Dan Friedeberg, recently sat down and interviewed Senior Vice President, Richard Davidson about the current state of the market for construction loans. The following are excerpts from the 7/31/2017 interview:

Friedeberg: “What is causing the current tightening in the construction loan space?”

Davidson: “One of the main drivers of this tightening is increased bank regulation.  The implementation of HVCRE (High Velocity Commercial Real Estate) rules that went into effect for the banks at the beginning of 2016 has made a large impact in the space.  This causes acquisition, development and construction loans to be reported separately from other CRE loans and to be assigned higher risk weighting by the banks.  These requirements typically mean that the borrower needs to infuse more cash equity into their projects.  Additionally, lenders have not forgotten losses associated with the recession of 2008 and this has caused banks to tighten their underwriting standards.  Even with the past recession behind us, there is concern about where we are in the current economic cycle and what lies ahead.”

Friedeberg: “Have lenders become more conservative in their underwriting of construction loans over the past year?”

Davidson: “Banks certainly have become more conservative with the new regulations.  With banks, borrowers have to show they have 15% of the completed value in the project in cash equity up front and that it will remain in the project until the loan is repaid or converted to permanent financing.  The result of this is shown in reduced loan amounts based upon both LTV and LTC ratios.  Consequently, the amount of equity required by sponsors to complete these transactions has increased.  

In this climate of conservative lending, many funds have stepped into this market where the banks have fallen short.  These lenders are not constrained by the same regulatory issues that the banks are and as such can provide higher LTV and LTC loans, of course at higher rates and costs.”

Friedeberg: “What are typical loan to cost requirements for preleased properties?”

Davidson: “Typical loan to cost requirements for preleased industrial, office or retail properties can vary widely depending on the quality of the preleasing tenants.  Generally speaking, banks will lend 60-65% LTC.  Of course, up until 2008, it was not uncommon for this ratio to be as high as 80% LTC.  With banks, the LTC ratio is impacted by the HVCRE rules discussed above.  Funds can underwrite higher LTV and LTC loans as they are not subject to the same regulatory oversight as banks. Some private lenders can structure LTC up to 80-90% and in some cased as high as 95% LTC in exchange for equity in the project.”

Friedeberg: “Is it possible to get s spec construction loan in today’s market?”

Davidson: “There are a great variety of spec construction loans being done at this time.  Apartment construction is one area where this is quite prevalent as buildings typically lease once they are completed.  Downtown core markets offer the opportunity for spec construction loans on office buildings as well.

Spec industrial, retail, and hospitality properties, are much more of a challenge to finance.  Construction financing on these property types has inherently greater risk than permanent lending because of the entitlement and construction risk involved in getting a building built.  When you have no preleasing, there is incrementally more risk associated with the loans.  

There is a saying I like.  “Don’t tell me it can’t be done, tell me how we can do it”.  While banks have a more difficult time with spec lending, private lenders and funds will finance spec projects. However, expect to pay a premium in fees and rates for loans from private lenders and funds.”

Friedeberg: “What types of properties are lenders actively pursuing?”

Davidson: “Certainly apartment construction lending is at the top of most lenders desired product type.  This is following by preleased office, retail and industrial.  The stronger the tenant the better. Buildings with credit tenants on long term leases are relatively easy to finance.  On the other spectrum, spec office, retail, industrial, and hospitality, are very difficult.”

Friedeberg: “Are insurance companies active in the construction lending market?”

Davidson: “The short answer is yes.  Many insurance companies offer combination construction/perm loans. They are typically conservative in their underwriting and try to stick with pre-leased properties.”