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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2018

Create Value for Construction Financing

Partnerships are key at a time when project costs are skyrocketing

Create Value for Construction Financing

Commercial construction projects are at or near all-time highs in terms of dollar volume. Across the United States, new developments are cropping up at breakneck speeds. Today, the downtown areas of many burgeoning cities are marked with cranes and heavy equipment, all furiously breaking ground on the next blockbuster property. Simply put, construction is everywhere.

For lenders, one might think this is good news. But there is a flip side to any development project. Alongside the increasing rate of construction projects comes a dramatic rise in the costs of materials, labor and land. Commercial mortgage brokers should know that these costs affect more than just the contractors: They affect everyone involved with the project.

There are many reasons why construction costs have risen so dramatically in recent years.  After the financial crisis that struck a decade ago, a large number of skilled and qualified workers fled the construction workforce.

During previous recessions, contractors often sought out temporary work during the downturns and returned to construction after the market resettled. But the aftermath of the Great Recession was far more profound than any of these contractors had seen before. Many workers could not afford to wait the extreme length of time required for this market to successfully rebound.

Construction was, in effect, left at a complete standstill from about 2010 through 2013, and many journeymen abandoned the industry altogether. To make matters worse, the recession also significantly reduced the number of new workers entering the construction industry, leaving this void unfilled for the foreseeable future.

Roots of rising costs

The impact of this labor shift was not fully realized until 2016 or so, when a balanced economy led to an increase in construction. But this new boom was ultimately met by an extreme shortage of labor.

As more new developments were planned, the demands for construction were unable to be met with the amount of labor available. As a result, developers and general contractors began to “steal” workers from other projects, traveling to competing sites and poaching their employees by offering them higher wages or better benefits.

To combat this, many contractors hired security guards to stop any labor poachers. In previous economic cycles, acts like this were unheard of, so they signified how deeply the recession and resulting labor depression had affected the market.

Contractors also have been challenged recently by a lack of foreign-born workers. Undocumented immigrants, for example, account for about 13 percent of the construction workforce in the U.S., according to the Pew Research Center, and those figures exceed 40 percent in border states like California and Texas. From 2006 to 2016, the number of immigrants working in the construction industry declined by 5 percent, according to the National Association of Home Builders.

In addition to the escalation of labor costs, there has been a dramatic increase in recent years in building-material and land-acquisition costs. As the economy began to heat up again and development resumed, land costs inflated just as quickly.

In many areas, commercial real estate values have surpassed their 2007 peaks. Developers have actively sought out entitled sites that are ready to break ground in order to reduce the time exposure on their deal and allow them to begin construction immediately after purchasing a permit-ready site. The speed of purchases has led to a massive increase in land costs that, when coupled with increased materials and labor costs, is significantly amplifying the overall cost of construction.

Lenders feel effects

All of these factors have affected more than the construction industry itself. They have reverberated all the way into the sphere of construction lending. As costs increase, developers find themselves squeezed in terms of their profit margins. Developers are generally optimistic by nature, however, and they make strong bets that once a construction project is complete, local wages will rise and so will rent prices.

Therefore, developers can easily justify increased costs, hypothesizing that these movements will inevitably lead to higher profits. Lenders, however, are inversely pessimistic and do not see the world through the same lens as developers. This divergence in views causes a significant disruption in the marketplace and has led to the derailment of many projects.

Traditional banks and private lenders base their financing on a loan-to-cost (LTC) ratio. Banks may be more conservative in their numbers than private lenders, but the underlying concept is the same. Banks will often lend up to 65 percent of a developer’s costs, whereas private lenders may come in with 75 percent or more of all expenses — including soft and hard costs, as well as land values.

Mortgage brokers and borrowers might wonder, if lenders base the loan amount on LTC, why would the increase in construction costs affect loan approval? Shouldn’t lenders proportionally follow LTC ratios and therefore lend more capital in relation to the costs? Developers likely work under this assumption but, for lenders, the issue is far more complex.

Reality-based budgets

Lenders see another variable inside the puzzle, believing that construction costs inhibit the creation of profits and, therefore, they see developers as essentially working for free. By their estimation, the overall value of the project has not increased by the same percentage as the rise in construction costs.

Lenders may feel that, for some development deals, completing the process will not lead to the creation of any value. Although construction lenders base loan approvals on LTC, they ultimately require limited exposure on the evaluation side of the deal.

Some lenders, therefore, come with set limits. Others may not specify a strict limit but generally exercise caution if the loan amount exceeds 65 percent of the project’s estimated value after construction. Even if they lend upward of 75 percent of the costs, they are wary of loans that will comprise 70 to 72 percent of the project’s future value. At that point, lenders find themselves questioning whether participation in the project makes sense at all.

Although it is unreasonable to believe that every project should work for every lender, more deals can be closed than not by integrating creativity and
 flexibility into the review process.   

So, if construction costs continue to rise, what can be done to help remedy the situation? For mortgage brokers working with developers, take care to ensure that the project budget is structured at a realistic price point. Inflated costs will end up hurting the development because experienced lenders will naturally scale the numbers back toward reality.

Take a thorough look at local rent statistics and do not expect growth over the next 24 to 36 months. Maybe the economy will expand and rent prices will rise, but this should be a bonus rather than an expectation.  Base a pro forma loan agreement on today’s values, not an artificial projection of what may or may not occur. 

Respect the process

Mortgage brokers should expect lenders to conduct a thorough review of the project and seek to fully understand all of the development’s metrics. Some lenders may conclude that rejecting a deal is safer than approving a loan.

Before denying a proposal, however, lenders also should first try to understand what the borrower is attempting to achieve. Each borrower is specific and, therefore, comes with a unique set of demands, procedures and goals.

Although it may seem like a borrower is attempting to force the impossible, lenders often can clear up misunderstandings by executing due diligence — which includes thoroughly reviewing the project drawings and budget — and by performing a proper site visit. They should not simply dismiss a project based on location, leverage or even the borrower’s history.

Brokers should work with lenders that give each project a fair chance and — most certainly — the time it deserves. They should not dash that work and commitment without first giving it proper time and respect.

Mortgage brokers and borrowers spend a great amount of time creating developments that are ready to quickly and efficiently break ground. Some developers spend years ensuring that a project can be executed profitably. Although it is unreasonable to believe that every project should work for every lender, more deals can be closed than not by integrating creativity and flexibility into the review process. 

• • •

In short, there is not much that can be done to stop the escalating costs of construction. Market forces have been set in motion, with commercial-property developers and mortgage brokers the unfortunate subjects of the whims of the economy.

By creating a closer and more efficient partnership between brokers, borrowers and lenders, however, more construction deals can be executed than ever before. By working to make comprehensive sense of each deal, the rate of closings can increase at a rate proportionate to the rising costs of construction.


 
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