By Brandon Wilhite
By virtually any measurable standard, the US economy is healthy and growing at a reasonably healthy clip, including annual GDP growth of about 2.5% in 2017. Most economic indicators, including guidance given by the Federal Reserve of three additional rate hikes this year, suggest strong economic growth is expected to continue through 2018. Economic growth is typically accompanied by increased demand for all types of real estate, residential and commercial real estate alike, and with that demand comes a need for new construction.
Unfortunately for both real estate developers and their tenants, construction financing has been stubbornly difficult to obtain. Banks, in particular, have tightened their purse strings on construction loans, citing the duration of the current expansion cycle (8 ½ years and counting), regulatory hurdles such as High Volatility Commercial Real Estate (HVCRE), and uncertainty over how well the existing construction pipeline will be absorbed by the market. Accordingly, banks have become far more conservative and selective on the construction projects they are willing to lend on. Whereas in previous cycles, banks would issue construction loan commitments in the 60% to 75% range, many banks are reducing their leverage commitments to 50% to 65% – particularly on speculative projects.
While more institutional sponsors have little to no problem bridging the funding gap, rounding out the capital stack behind a low leverage construction loan can be quite challenging for entrepreneurial real estate developers who are typically dependent on raising outside equity to fund their projects. Over the past few years, these entrepreneurial developers have addressed this issue by raising a slice of Mezzanine Debt or Preferred Equity into the capital stack behind the senior loan, but in a priority position to the common equity. Although the cost of this subordinate capital may induce some sticker shock with coupons ranging from 9% to 14%, when combined with the senior loan, the blended cost of capital and increased leverage were sufficient to right-size the equity requirements and yield an attractive risk-adjusted return to investors.
Recently, private lenders and debt funds are making their way into the market and funding senior construction loans up to 85% in some cases. Interest rates on these loans range anywhere from 200 bps to 900 bps over LIBOR, depending on leverage, recourse, asset type, and market. For the most part, but with some exceptions, this type of financing is currently limited to loans $20 million and up, top 20 MSAs, and very experienced sponsors. It is expected that additional lenders will continue to gradually enter the market with lending criteria more tailored to entrepreneurial developers in secondary markets where there is currently a void.
Even in a thriving economy, obtaining construction financing is as challenging as it has ever been, as the usual suspects (banks) have pulled back and new, unfamiliar players have entered the market. At Metropolitan Capital Advisors (MCA), it is our daily business to keep close tabs on all financing options so that we can assist our clients in creating value and profit in their real estate projects. Please contact us to see how you can benefit from our experience and market knowledge.
The author, Brandon Wilhite, is a Senior Director in the Dallas office of Metropolitan Capital Advisors. Brandon can be reached at [email protected] or 972-267-0600.