CAPTIAL MARKETS: CONSTRUCTION FINANCING

APARTMENT FINANCE TODAY • FEBRUARY 2008

Putting the Squeeze On

The credit crunch prompts construction lenders to cut proceeds.

By Brad Berton

Amid the ongoing credit crunch, the most entrepreneurial apartment developers—those who seek the maximum amount of construction debt available for their projects—are swallowing a dose of lowerleverage reality.

They have to come up with more upfront cash than they’ve had to in years—typically a difference of 5 percent or so more of a development’s cost.

That’s because banks are sizing construction facilities based on the lesser loan proceeds that permanent mortgage lenders are offering as operating income stabilizes. And the active apartment lenders are underwriting much more conservatively than was the case just a few calendar quarters back, when Wall Street conduits were at their most liberal with loan proceeds.

“Just like with Hollywood celebrity bodies, it’s all about back-end for construction lenders,” said Mike Guterman, principal and CFO with Los Angeles-based Highland Realty Capital, which secures construction financing for developer clients. “They’re focusing on what take-out lenders are likely to provide on the back-end, and that’s one of the primary guidelines restricting construction loan proceeds.”

With permanent lenders adhering to more conservative debt-coverage requirements, the maximum construction proceeds available for any given development are typically down by 5 percent or more, according to Guterman and other multifamily finance pros.

Most construction lenders today prefer to keep leverage at 75 percent or less of a project’s costs, rather than the 80 and even 85 percent seen before the crunch hit last year, said Mark Sixour, senior managing director at Holliday Fenoglio Fowler in Atlanta. Many lenders will still go up to 80 percent in some cases, but they’ll charge a substantially wider interest-rate spread for that last 5 percent of capitalization, likely 500 to 650 basis points over the LIBOR index, Sixour said. LIBOR, the London Interbank Offered Rate, is a frequently used benchmark rate for multifamily loans.

Widening spreads

In addition to receiving less in proceeds, shallow-pocketed developers are paying wider interest spreads for construction debt these days.

While construction spreads vary widely depending on leverage levels, borrower creditworthiness, and other risk-related factors, the spreads charged to entrepreneurial developers for the highest-leverage construction facilities tend to be about 100 basis points wider than they were as 2006 turned to 2007, estimated Sixour and Brad Sevier, president of Highland Realty Capital.

The continuing turmoil confronting Wall Street securitizations, along with the general credit crunch, are the key factors here as well. When loan originators were still able to tap the collateralized debt obligation (CDO) marketplace through early last year, entrepreneurial developers were often able to secure non-recourse construction financing floating at or below 200 basis points over LIBOR, Sevier said.

But now that the CDO market is no longer viable for such facilities, the terms lenders typically require today for independent developers include some recourse at a 70 percent to 75 percent loan-to-cost ratio, with the debt priced in the vicinity of 250 to 350 basis points over LIBOR, Sevier said.

Predictably, pricing hasn’t increased as dramatically for deeppocketed, institutionally backed developers such as San Francisco apartment fund manager Carmel Partners. “I was just quoted a 75 percent loan-to-cost construction loan, from a large bank, at 150 basis points over LIBOR,” said John Williams, Carmel’s managing partner for capital markets. “Last year it probably would have been 135 over.”

But as higher construction-period interest costs aren’t likely to make or break a solid project even for thinly capitalized developers, perhaps the most daunting element of the changed lending environment is the reduction of available loan proceeds.

Limiting proceeds

Construction lenders are limiting proceeds based on requirements from active permanent lenders that projected operating incomes exceed monthly debt-service obligations by at least 20 percent, compared to the 10 percent (or even less) seen frequently in recent years.

Life insurance companies, Fannie Mae and Freddie Mac, and the few active conduits are mostly insisting on this 1.20x debt-service coverage ratio (DSCR) today, although some banks are allowing for a 1.15x DSCR for particularly strong markets and sponsorships, Sixour said.

Perhaps most significantly, permanent and construction lenders are more cautious with the assumptions they rely on in calculating likely operating incomes and debt-service obligations— and hence the total loan proceeds they’ll fund at any given DSCR.

“Now they’re really focusing on rent-growth assumptions, taking a much more conservative approach,” Guterman said. That means developers applying for construction loans and take-out quotes are required to provide more objective and thorough market analyses, he added.

Construction lenders are also factoring in today’s wider permanent mortgage interest-rate spreads, compared to pre-crunch levels, in calculating likely debt-service obligations. And they’re basing those obligations on amortizing payment structures, rather than the long-term interestonly periods that were wildly popular before the crunch.

“With conduits out of the game, sizing construction loans today entails using the higher DSCRs as well as the interest rates that (Fannie and Freddie) and life companies are likely to quote on the back-end,” said David Dewar, a principal with Tempe, Ariz.-based Trillium Residential, LLC, a luxury apartment developer.

The agencies as well as life company lenders have widened permanent loan spreads by 50 to 100 basis points since the volatility hit, said Highland’s Sevier.

Requiring recourse

The movement toward more conservative lending isn’t just a matter of proceeds and pricing. Compared to just a year ago, construction lenders today are also requiring developers to pledge more personal assets beyond the collateral real estate as recourse for soured loans.

Developers were getting used to construction facility structures with little if any personal recourse beyond the standard completion guarantee, Guterman said. But now lenders are looking for repayment guarantees amounting to at least 25 percent of the loan amount, he added.

And entrepreneurial types should expect heavier scrutiny of their credit histories, added Sevier. “Lenders are still reviewing credit reports, litigation searches, financials, and resumes, but they have raised the bar in terms of what is acceptable” when it comes to funding a construction facility, he continued. “There’s simply less tolerance for risk, as they want to get very comfortable the borrower can carry the project in the event the lease-up takes longer than expected.”

So in contrast to the Hollywood scene, thin is definitely not in when it comes to apartment construction lending today. Indeed, a lot of lenders have simply lost interest in funding projects by thinly capitalized developers or those with no experience in the targeted market, Sixour said.

But he and others remain confident construction and permanent underwriting will eventually liberalize once again as commercial mortgage-backed securities buyers get comfortable with the sector’s riskadjusted returns. And that expected boost to liquidity should ultimately allow for higher-leverage permanent mortgages and in turn greater construction loan proceeds.

“The return of liquidity should help at least with respect to sizing construction loans,” Dewar said, adding that a stabilized conduit lending arena will likely lead to “relaxation” of the prevailing 1.20x coverage requirement.

Nevertheless, the bottom line for the time being is that entrepreneurial apartment developers need to come up with more cash, outside equity, or mezzanine capital. And predictably, equity sources and mezz lenders are requiring higher yields in this higherdemand environment.

But that’s another story.