Understand the Ask: Construction Financing Basics

October, 2015

Construction financing is a little different than other loan types. Understanding the basics will help you be successful, and will also help to ensure that you are working with your lender to put a structure in place that will help to ensure success of the project; after all, if you are not sure what to ask for when preparing the loan request, how are you going to get what you need?

  • Term - Prior to the market crash in 2008, many construction loans had a term of 36 months. However, due to a slowing economy, many facilities were not stabilized at the end of the loan term, leaving the borrower and the bank in a precarious position. One of the major lessons learned by borrowers was to ensure sufficient cushion in the loan term in order to allow for slower than anticipated lease up. If possible, try to negotiate a four or five-year term with as long of an interest only period as possible. You may also request that they build an "extension option" in to the term to help avoid this pitfall.

  • Interest Rate - The interest rate that a lender will charge can vary greatly depending on a number of factors, notably including advance rate and investor equity, as well as borrower experience and strength. Generally speaking at the time of this writing (2Q 2015) variable rate loan spreads are currently ranging between 200 and 450 basis points over the 30-day LIBOR, and 25 to 250 basis points over Prime; this generally equates to rates in the 2.50 percent to 5.0 percent range. On a fixed-rate loan, active construction lenders are offering three to five year fixed rates between 4 percent and 6 percent. These are historically low rates, and are a factor that currently makes development very attractive, because it can significantly reduce the overall interest carry and ultimate cost of construction.

  • Loan to Cost (LTC) - The conventional LTC constraint is fluctuating between 60 percent and 75 percent, depending on the transaction specifics; this means the sponsor should be prepared to put equity of 25 to 40 percent in to the project. The LTC is dependent on the bank, the strength of the borrower and the quality of the deal. A borrower with a short track record in self-storage and a reasonable project may be required to fund 40 percent of the project cost with equity, whereas a strong borrower with a long track record may be able to achieve 75 percent LTC. Higher LTC loans are also more easily achieved when the delta between the construction capitalization (cap) rate and the residual cap rate is larger. At lower LTC requests lenders may be willing to reduce the guaranty requirements and offer partial recourse to the borrower, or structure the deal such that recourse "burns off" as the project stabilizes and increases in value.

  • Interest-Only Periods - Interest-only refers to what is included in the payments made to the bank during the loan term; there are no principal payments or amortization of the debt during an interest only period. Most construction loans are structured as interest-only during the construction period; however with self-storage it is important to remember that lease up does not happen overnight. Because there is no cash flow during the construction period and it may take a couple of years before the property leases-up to break even occupancy, banks will often allow the borrower to pay only the interest due and not require amortization of the principle during this critical period of the loan. It is critical to carefully examine the proposed period of lease-up and mirror the interest-only period of the loan to the projected lease up.

  • Interest Reserves - An important part of the project costs is the calculation of the interest reserve that is required to carry the property to break even cash flow. The interest reserve allows the sponsor to "borrow" the funds needed to make the monthly interest payments during the time when the property cannot support itself, which is extremely helpful during the construction and leasing phase. If no interest reserve is set up when the loan is negotiated, interest payments will need to be made out of the borrower's pocket with equity. It's important to negotiate a large enough interest reserve to carry the project through lease-up and provide a bit of a cushion in case of construction delays or slower than anticipated lease-up.

Articles: October 2015

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