In April 2007, New Century Financial, the nation's largest nonprime residential lender at the time, filed for bankruptcy protection. This company was the first major financial institution to falter in this cycle, but it was followed by additional companies – creating the current financial climate known as the credit crunch.
As the credit crunch continues to put negative pressure on lenders' balance sheets, securing financing for land and construction projects has become a unique challenge. In the current market, banks have significantly tightened their underwriting standards.
Potential borrowers are best armed to deal with these new challenges by having an understanding of how these standards have changed and what lenders are focusing on now versus 18 months ago.
Product selection is one primary way lenders are changing their standards in order to minimize their risk. Banks are limiting their exposure to anything that is for sale, including residential units or homes, office and industrial condominiums.
Lenders have very limited interest in these product types because of how closely they are tied to the end user's ability to finance itself. With Small Business Administration loans and home loans harder to obtain, lenders are pulling back on providing construction financing for these types of products.
Furthermore, banks are not entertaining any land financing due a multitude of factors including the lack of sale activity, difficulty in valuing land and the lack of construction financing.
Banks still have an interest in financing the construction of apartment, office, industrial and some retail properties, but retail is beginning to lose favor with banks due to a wave of negative news from the nation's retailers. Over the past several months, 27 national retailers – from Home Depot to Starbucks – have announced store closings, making banks more skeptical in lending to companies undertaking new projects or redeveloping older retail projects.
A second point of focus that lenders are looking at more intently than ever is location. Lenders are eager to provide financing in infill areas where there is an established population and, more importantly, a track record of success.
Pioneering projects and projects in secondary and tertiary markets, on the other hand, are dependent on ever-expanding population growth and are thus less likely to receive financing.
Project scrutiny
The third change evident in underwriting standards is the manner in which lenders are underwriting sponsors. Sponsors need to have a strong development track record in order to be considered for construction financing.
Specifically, lenders want to see that the developer has past experience in building the type and size of project they are trying to finance. In addition, sponsors must be willing to sign personal recourse and a completion guarantee or, at a minimum, limited recourse to obtain financing.
Eighteen months ago, there were approximately six major nonrecourse construction lenders. Today, nonrecourse construction loans are essentially a thing of the past.
As a result of this change and tightened credit standards, banks are now scrutinizing sponsors' financial statements to a greater extent. Lenders are conducting detailed analyses of sponsors' real estate schedules and contingent liabilities on their ongoing projects.
To keep their risk reasonable, banks want to ensure sponsors have the necessary liquidity to cover potential capital requirements on existing projects before granting new loans. With these heightened standards, only strong borrowers with sufficient existing capital are able to secure construction financing in today's market.
All three of these specific factors – coupled with a slowdown in construction loan payoffs and certain banks abandoning their loan origination platforms in order to focus on resolving issues within their loan portfolios – have resulted in limited availability of construction financing.
A good illustration of how the banks have tightened their credit underwriting can be found in a deal in which we recently participated. A residential developer was seeking financing for a small, infill, 4,000 square-foot retail center that it wanted to build in Orange County, Calif. The project was located along a major arterial road and was anticipated to be 100% pre-leased with executed leases prior to loan funding.
The development company was very liquid and did not possess a large body of ongoing residential projects. The deal was presented to 12 banks to obtain a construction loan to cover 70% of the project cost.
Of those 12 banks, only three expressed interest in financing the deal. Prior to issuing a letter of interest, all three potential lenders requested federal tax returns and detailed personal financial statements from the sponsor.
Furthermore, all three lenders expressed deep concern over the lack of retail development experience of the sponsor, despite the fact that the development company has been in the residential development industry for more than 20 years. Eighteen months ago, this project would have attracted interest from all 12 lenders without hesitation or the requirement of such extensive financial information from the sponsor.
No securitization
In recent years, construction lenders have become more reliant on commercial mortgage-backed securities (CMBS) financing as a form of repayment for their construction financing. Today, of course, securitized permanent financing is simply not available.
Therefore, all permanent financing is on-book through banks, life companies and credit companies. These permanent lenders, however, have scaled back their maximum loan-to-value (LTV) from the previous range of 80% to 85% to the current 60% to 70%.
The LTV ratio is being further constrained by minimum capitalization rates that lenders have instituted for various product types and regions in the country.
Lenders have reverted back to utilizing stressed mortgage constants and a 1.25 to 1.35 debt service coverage ratio (DSCR) to underwrite the loan, based on a debt service constraint test. As a result, loan proceeds have been cut back significantly.
Lastly, in today's climate, pre-leasing is absolutely necessary. Lenders will likely require a minimum of 50% pre-leasing – defined as executed leases – before providing funding.
Yet another aspect that has tightened recently is lenders' underwriting of the loan-to-cost (LTC) sizing tests. In general, lenders have scaled back their LTC ratios to 60% to 70% from the former 75% to 85% and are now requiring the sponsors to have cash equity in the project. They are no longer accepting imputed land equity as a substitute for cash.
Securitization of construction financing was previously utilized for construction loans over $100 million. In the past, construction loans have also been securitized through collateralized debt obligations.
The latter method allowed lenders to sell pieces of a securitization to the secondary market, which provided a credit facility that they were able to fill with floating rate loans. Those securitizations were popular for subprime and home mortgages that were not purchased by Fannie Mae or Freddie Mac.
This type of securitization was among the first to be affected by the current downturn in the securitization world. There is no immediate speculation for when it might recover.
Despite these struggling areas, permanent apartment finance is one area of the market that is still going strong. Freddie Mac and Fannie Mae are, however, following the underwriting trend of other institutions by tightening their lending standards and increasing credit spreads.
Eighteen months ago, loans, for instance, were underwritten as low as 1.10 DSCR. Today minimum DSCR requirements are 1.15 for strong markets and 1.25 for some of the hard-hit markets like Phoenix, Las Vegas and the Inland Empire. Like construction lenders, Fannie and Freddie are scrutinizing sponsors' financial statements.
Lastly, mezzanine financing was available with Fannie and Freddie going down to 1.0 DSCR to a 1.05, while today, this financing is no longer being offered by either lender. On a positive note, both lenders have come out with new lending programs that seek to fill the void left by other financial institutions.
These programs include financing for acquisition rehabilitation, student housing and an on-book conduit program that will provide borrowers approximately 5% more loan proceeds at slightly lower spreads – but will have the stringent prepayment provisions of traditional CMBS loans.
Condo conundrum
Current market struggles have also affected the outcome of many condominium construction projects. Developments intended to be condominiums are, as the process progresses, being shifted into apartment complexes.
The issue with these projects is that the original land price for these developments does make apartments financially viable due to the high price of land. Furthermore, projects cost more to build as a result of the higher construction specifications of condominiums relative to apartments.
Meanwhile, condominium sale prices have plunged and, in many cases, there are no buyers. The developers of these projects are forced to rebalance their equity to convert their projects to apartments that have much lower valuation than their original projected condominium sell-out value.
Increased scrutiny is naturally very prevalent with these shifting projects. Lenders will not allow a developer to lease units and shift a condominium project loan to an apartment project loan without implementing their own underwriting. Lenders are careful to secure their exit from these shifting projects, using the same intense standards with existing loans as they do with new loans.
We are currently financing an apartment project that is a telling example of this environment. Eighteen months ago, the sponsor purchased the land with the intention of building a condominium development on it.
After spending nearly 18 months navigating the entitlement process with the city of Los Angeles, the sponsor found the deal was challenged by the current state of the market and was unable to sell the units at the originally projected prices. As a result, the project had to shift from condominiums to apartments.
In order to make the project feasible as apartments, the sponsor went back to Los Angeles and requested an increase in the number of units from 90 to 140, as was allowed under the city's zoning code. However, the lender, which funded the land loan at the time of acquisition, indicated that it no longer had thr capacity to fund a construction loan for the apartment project.
Upon underwriting the deal to current LTC and debt service constraints, the lender advised the sponsor that it would require an additional $6 million above the $14 million that the sponsor had already planned on investing in the project.
To make the project work, the sponsor approached the current lender and made a request to convert $4.5 million of their $9.8 million land loan to a mezzanine loan for the project. The lender agreed to his proposal and, along with his additional investment of $1.5 million, was able to get lenders to finance the project.
As lenders continue to navigate the challenges of today's economic climate, the market will continue to experience increased scrutiny on both new and existing loan standards for land and construction projects.
Borrowers seeking funding for projects in infill areas with a proven track record of success – and who are mindful of their product type – will have the greatest success in securing funding. Borrowers with a strong base of existing capital are also more likely to weather the current economic storm.
Shlomi Ronen is a senior vice president with Los Angeles-based investment banking firm George Smith Partners. Since joining George Smith Partners in 2001, he has arranged or assisted in the placement of over $500 million in debt, mezzanine and equity financing for office, industrial, retail, condominium and multifamily. He can be contacted at (310) 557-8336, ext. 127, or sronen@gspartners.com.
