BY MATT FISHER, MIKE GURTOVOY, AND MAX CANCILLA as published in the 425Business.com Magazine
It’s a tough world out there for developers. The days of banks financing 75% of your total construction cost are now firmly in the rearview mirror, and developers are getting clobbered by the one-two punch of historically high hard costs and interest rates. We have been inundated with inquiries from folks asking how to secure financing for their next project, so we collected our thoughts and developed the following few pieces of general advice.
First, let’s address the 30-ton concrete mixer in the room: Are hard costs ever going to come down? Basic supply and demand dictates that as fewer projects get underway, the demand for materials and labor should drop, thereby bringing costs down. We called Jeff Richards, president of Absher Construction, to get his perspective.
“Absher continues to monitor the markets looking for pricing relief for our clients,” Richards said. “We are seeing an increase in the volume of subcontractors actively bidding projects, which is creating downward pressure on total cost. Unfortunately, this is being offset with supply chain impacts and commodity pricing, which continue to drive upward pressure. We anticipate a slowing of price escalation and expect it to level off in the near future, but we are not currently seeing any downward pressure on total contact values.”
The market isn’t there yet. Whether interest rates will drop is even less clear, and the Fed’s rate hikes haven’t exactly been steps in the right direction. While some developers are opting to wait out the storm, others are forging ahead. Should you find yourself in the latter group, we hope you find some of these pointers helpful.
Accept the new reality of lower-leverage bank loans.
Most banks underwrite their construction loans to a debt service coverage ratio that is based on a hypothetical “take-out” rate. When doing so, they underwrite to a conservative, future rate, which assures them that the property will service the debt at stabilization.
Today’s high interest rates result in loan amounts that are vastly lower than they have been in recent years. Do not waste your valuable time hunting for nonexistent 75%-80% levered bank financing.
Leverage your deposits.
Most regional banks today have an inadequate loan-to-deposit ratio. Generally, the more a bank has in deposits, the more it can lend. Offering to move your accounts to a regional bank that is hungry for deposits will increase their interest in your project.
Consider nonbank financing.
There is no shortage of structured financing options, since deal flow for mezzanine lenders, preferred equity providers, and CPACE lenders is slow. These lenders might be able to help increase your leverage in addition to a senior loan.
Make sure that your project “pencils.”
Start with a good estimate for the total cost of development (which includes a healthy contingency). Then construct an accurate untrended proforma: If your building were built and stabilized today, what would the NOI figure be? Compare the cost figure with sales comps for similar properties being sold today. The delta between the costs and “today’s” valuation will be your estimated profit. Typically, developers target a 10%-25% margin or a 100 bp spread between the yield-on- cost (untrended-NOI/construction cost) and the market cap rate.
A bird in the hand.
We see it all the time. A developer has a quote from a lender that works for them, but they sit on it while they continue searching for a lower rate that doesn’t exist. By the time they realize the quote they have is in line with the market, rates have risen, and their original set of terms is no longer on the table. If you have a quote that pencils, take it while you can.
The current marketplace for commercial real estate construction financing is challenging but not insurmountable. Should you find yourself on the hunt for construction debt, then consider lower leverage, moving your bank deposits, and nontraditional sources of financing. Lastly, listen to the market, and trust the advice of seasoned experts who have been through a few cycles. Capital still exists for projects that “pencil,” but it sure won’t look like it did 12 months ago.
The article above is written by Matt Fisher, Mike Gurtovoy, and Max Cancilla. The views, thoughts, and opinions expressed herein belong exclusively to the authors and are not necessarily those shared by all lenders or other mortgage bankers or brokers in the industry.