Construction Loans 411

Before you contact potential lenders with a construction project that needs funding, it’s essential that you understand the transaction. This is especially important given the numerous moving parts involved in these loans.

Here are some of the most-important items to consider.

The summary

Writing an executive summary not only will give you a concise picture of the moving parts, but it also will allow you to shop your loan faster to more lenders as you search for the right funding source.

Every executive summary should contain detailed information about the following:

Property location

• Project details, such as the number and type of units, proposed unit pricing, total project cost and cost per plan
• People and entities involved in the project
• Status of the project’s phases, which include the site acquisition, plans and permits
• Takeout loan and exit strategy

When summarizing a project, remember some less-obvious questions and facets specific to construction lending. For example, lenders will want to know what progress has been made on this project. Are plans prepared or building permits obtained? Who owns the project site? What is its current physical condition?

Further, be prepared to explain if there are existing structures that must be demolished and removed. For a housing tract or subdivision, have the projects seen infrastructure improvements such as utilities, sidewalks, curbs and streets?

In addition to an executive summary, most lenders will require:

• A pro forma income-and-expense statement (if the completed project will be leased or rented) or sales figures for the project
• Borrowers’ personal financial statements
• The project’s construction budget, including a breakdown of hard and soft costs, land costs and interest reserve
• General contractors’ or builders’ résumés, including licensing information
• Developers’ résumés, with particular emphasis on successful experience

Depending on the project type, an often-overlooked item is a preliminary market study or other due-diligence research supporting the project’s viability. For a rental or leased property, a report discussing market vacancy and absorption rates is useful. A for-sale-when-built project requires similar data about competing projects.

Project viability

Once they understand the basic parameters of a project, construction lenders often want to learn about the exit strategy upfront. A construction loan is essentially a bridge loan — one that converts a project from one form (raw land or a building to be demolished or rebuilt) to another (a newly completed project). Thus, banks are only interested in projects that pencil out.

The takeout loan or permanent loan that pays off the construction loan at the end of its term is predicated on the occupied property. The construction timeline that you give to the lender, therefore, must consider the time it will take to lease-up the property if it is a rental project.

With for-sale projects such as condominiums or single-family homes, the construction loan will be retired from the sales proceeds. So the timeline must account for the time it will take to market the units. In addition, an allowance must be made for sales costs such as marketing, advertising costs and sales commissions.

As part of their project-viability analysis, lenders will want to see a pro forma that projects income or cash flow to prove the financial worthiness of a project. For apartment construction, they’ll also want to see income-and-expense statements and rent rolls. For condo-conversion projects, they’ll want to see “as is” income-and-expense statements and rent rolls to demonstrate how the subject would perform as an apartment property.

Successful brokers should run the numbers on the proposed project to ensure that the cash flows will support a loan large enough to pay off the construction loan.

The budget

There are five main components of project costs:

• Land (or land and building, if there is an existing structure)
• Hard costs
• Soft costs
• The interest reserve
• Contingency provisions

Understanding who owns the land, how much it cost and how much debt is on it, if any, is essential to a successful transaction.

The cost of the land is pretty straight-forward. How much did the developer pay for the land, and when was it purchased? Be sure to find out if there is currently any debt on it. Often a developer will truthfully tell the broker, “I own the land,” but will fail to mention that it is mortgaged.

Or a developer may tell you something along the lines of, “I paid $1 million for the land, but it’s worth $2.5 million today.” While that may be true, most construction lenders will base their underwriting on the purchase price rather than on the current market value. The primary exceptions would be if the developers bought the land several years ago. But if your clients bought it last year, they’re going to have a hard time convincing the lender to value the land at today’s market value.

Generally, hard costs cover the things one can see — such as steel, bricks and wood. Soft costs cover such items as plans, permits and engineering specifications. Both are essential parts of the construction project, and both must include a contingency cushion. After all, like so many things in life, construction projects rarely go exactly as planned.

From a lender’s standpoint, construction loans are among the riskiest products offered. One way lenders mitigate those risks is to ensure there is enough money in the deal at closing to pay the interest during the loan term. Because the project will not generate a positive cash flow during the construction process, the estimated amount of interest that will be due on the loan must be reserved upfront.

The lender will estimate the size of the required interest reserve based on the characteristics of each transaction. For example, a large initial loan disbursement to purchase and demolish an existing building will require a larger reserve than a loan in which the borrower has owned the land for many years. Generally, the lender will fund the interest reserve from the loan proceeds.

Delays often are possible in a construction project, and they can be expensive. There is only so much money in the established interest reserve. A realistic plan must include some cushion or other margin for error. There are, for example, contingency line items in both the hard- and soft-cost budgets. If a project will require perfect planetary alignment to succeed, it will be a tough sell to the construction lender.

Financial foundation

Successful construction projects and the loans that build them rest on a solid foundation — cash. Construction lenders always want to talk about cash. In other words, how much cash do the developers have in the deal?

Assuming the borrowers have a land parcel, they will likely want to sell the deal by talking about future land values. From the lender’s perspective, however, although future value is important, it is in the future. Because lenders loan money in the present, they want borrowers with a significant cash position in the transaction. Generally, lenders seek developers who can come to the closing with 20 percent to 30 percent of the total project cost.

Loan to value also is important. With construction of for-sale projects such as condominiums or tract homes, the bank will underwrite to a discounted or bulk value. Developers tend to concentrate on aggregate value, however. So you should help them understand that the bulk value will be preferred over the aggregate value.

To reach the bulk value, lenders will typically deduct marketing and sales costs from the value. For example, an 8-percent market-and-sales commission cost factor would account for a reasonable commission (6 percent) and the costs of advertising and marketing (2 percent). Lenders will further discount that value depending on the property type, the overall market, and the financial strength and experience of the borrowers. Once they’ve factored in these discounts, they arrive at bulk value. Final figures generally are subject to the appraisal report.

Why do lenders prefer to use a bulk value? Because they loan money by thinking about what they will have to do if they take back a failed project. In the event of a foreclosure on a failed project, lenders probably will sell the entire project in bulk, rather than attempt to market the units individually.

Experience

Any construction lender will ask about your clients’ experience. Lenders are more comfortable with applicants who have completed a comparable project before. When preparing a deal summary, smart brokers include the applicant’s successful construction history or résumé.

It is understandable that someone who has built and sold several single-family homes wants to move up into a small apartment project. Just be sure to explain that story to the lender.

This doesn’t mean all construction loan applicants must be successful general contractors. They can hire a contractor. But lenders will ask for the general contractor’s résumé, so have that ready.

Lenders will want to know if the borrowers or contractors are local or from out of the area. People working in a new market may have a difficult time with everything from hiring workers to obtaining the necessary construction materials and working with the local planning department.

Overall, construction lending is a field in which previous successful experience makes a huge difference. If your clients are newcomers, they would be well-served to partner or join forces with someone who has demonstrated the ability to complete a complex project on time and on budget.

Other considerations

Applicants should never order their own appraisals. A federally regulated lender is forbidden by law to use an appraisal ordered by the borrowers. Sometimes your clients will be in a hurry and will want to speed things up by ordering the appraisal immediately. But once you explain to them that could cost them several thousand dollars and that the appraisal will not be used anyway, they will likely lose interest in that approach.

Construction loans are rarely stated-income or no-doc deals, so be prepared to collect documents accordingly. Most lenders require full recourse to the borrower. They will likely require proof that the applicants have the experience and financial resources to complete the project.

Mortgage brokers can do their clients a real service by negotiating at least one extension in the original loan. Most construction lenders will offer an extension contingent upon the loan being paid as agreed and otherwise performing per the loan documents. Again, given the uncertainties inherent in every construction project, this can prove to be an important provision.