Are lenders getting cautious?
September 28, 2017 Kevin Riordan

This week we are adding a new feature to our weekly newsletter by interviewing members of the Rutgers Center for Real Estate’s Advisory Board or Emerging Leaders Council to get their perspectives on current issues affecting their business. This week, Kevin Riordan of the Center sat down with Michael Klein, Managing Director at HFF to get his insights and perspectives on construction lending.

KR: Michael, before we explore current construction lending guidelines, requirements, etc., how do lenders see the property markets at this point in the cycle?

MK: Generally lenders are slightly more cautious at this stage in the cycle. Looking at the major property categories, I would say multi-family is still the most desired asset class with industrial projects a close second. However, I would clarify that lenders are not just accepting any multi-family project that should grace their doorstep. With less room for top line rental growth and a concern about oversupply in certain markets, lenders will be very reluctant to provide financing for developers that don’t have the financial wherewithal or a proven development track record. The time has passed where an inexperienced group can just tie up a site and then seek financing to build a multi-family community.  In many instances, lenders are hungrier for industrial properties and several are being financed on a spec basis. As we move down to retail and office properties, they need to be substantially pre-leased in a strong location to secure financing. Many lenders are concerned about the future of brick and mortar retail especially in the big box space. Sentiment is also starting to build that the country has too many grocers and lenders are only focusing on the top three operators in a market.

Michael Klein, Managing Director, HFF, and member of the Rutgers Center for Real Estate Emerging Leaders Council

KR: For lenders that provide financing, what changes to underwriting, structure and/or fees have you seen that will allow them to commit to transactions?

MK: The most visible impact to lending that we see is the amount of financing they will commit to the cost of a project. Previously it was 75 to 80% of cost. Today it is 60 to 70% of cost. Of course, there are exceptions especially for top tier real estate developers with strong existing banking relationships. The amount of recourse is also going up through repayment guarantees. For example, 18 months ago it was common for lenders to not require a repayment guarantee on a multifamily development. Now lenders are looking for repayment guarantees ranging from 25 to 50%. However, we are seeing some interesting exceptions. For example, we have secured several spec industrial construction loans in the 50-60% LTC range with just a completion guaranty. Many of these loans were made by life insurance companies. Finally, there are increases in fees.  Previously, fees averaged 50bps, but current requirements are starting as high as 75 to 100bps.

KR: When we say ‘construction financing’ aren’t we talking about monies that are available for two different uses?

MK: Yes, we source financing for both ground-up development and the redevelopment of existing improvements. For ground-up construction, your traditional lenders (banks and life insurance companies) are obviously the established source although we have seen some non-traditional lenders such as debt funds and REITs fill a void in the market. We are seeing the redevelopment or repositioning of projects being serviced more by the non-traditional lenders.

KR: Who are these entities you see stepping in to participate in some of the spots that the traditional lenders are vacating.  Who would you say is bridging the gap?

MK: The alternative or shadow bankers we have seen include debt funds, private REITs and insurance companies with separate accounts. We see plenty of liquidity. The bigger issue appears to be balance sheet related. I would say lenders are tapping the brakes given where they are in the cycle and some of the new regulations that have been established coming out of the downturn. But I will also say that lenders have placeholders for best in class developers with well-located projects and financing for them will remain readily available.

KR: So you indicate that it may be balance sheet issues which may or may not be related to asset exposure and/or portfolio limits. Can you also speculate on what may be affecting lender’s balance sheets?

MK: One regulation that is affecting availability is whether a loan is classified as HVCRE which stands for ‘High Volatility Commercial Real Estate’. If the loan is classified as such it carries a higher risk rating and additional capital must be reserved against the loan which many banks don’t want to do. Obviously bank regulations can be byzantine in their complexity but I will try to explain the intent of the rule and its implications.

First, the borrower has to contribute at least 15% of the “as completed” value of the property in cash or other marketable securities. The intent is to encourage borrowers to have invested significant ‘skin in the game’. So third party funds don’t count nor does other pledged collateral. And the borrower’s capital must be put in first. A latter injection will not help avoiding the HVCRE designation. Second, it is the borrower’s cash basis in their collateral that is counted. So if the developer acquired and held the land for an extended period, only the original purchase price and carry costs are counted for the test. There is no credit given even if you acquired the land and created an assemblage, and then either through rezoning, performing an environmental cleanup or other means created value for the parcel. You will get credit for certain costs put into the project but not the value creation.

KR: Michael, thanks for your time and giving us an update on the construction lending market.

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