SPECIAL FOCUS >> CAPITAL MARKETS OUTLOOK 2008

Construction Financing Unscathed by Credit Crunch

BY JERRY ASCIERTO

AFFORDABLE HOUSING FINANCE • NOVEMBER 2007

Affordable housing developers will be able to procure construction financing next year with relative ease, even as the rates and terms of permanent debt become more challenging. Unlike permanent loans, construction financing for affordable housing deals has been somewhat immune from the capital mess resulting from the subprime mortgage industry’s meltdown.

The Federal Reserve’s move to cut short-term interest rates half a point in September has already helped to bring stability to the troubled capital markets in the fourth quarter of 2007. At press time, Wall Street expected the Fed to cut rates at least once more. In the wake of those declines, construction rates are likely to hold steady, or even fall, in 2008.

Developers report that construction financing for 9 percent and 4 percent tax credit deals was affordable through the summer’s credit crisis and into the fourth quarter of 2007, a trend they expect to continue into 2008. “With all the turmoil in the capital markets, you would think it might not be that way,” said Todd Sears, vice president of finance for Indianapolis-based affordable housing developer Herman & Kittle Properties, Inc. “For construction [loans], terms have held steady or in some situations, they’ve gotten a little bit better.”

Rates on construction and bridge loans often float over the six-month London Interbank Offered Rate (LIBOR). The six-month LIBOR steadily rose through 2006 and most of 2007, climbing from 4.68 percent in January 2006 to 5.53 percent at the end of August. But it began inching down in the fall to 5.06 percent in September, its lowest since March of last year. Developers expect LIBOR rates to stay in the low 5 percent range into 2008.

Throughout the credit crisis, rates on construction loans stayed the same or even improved for both taxable and tax-exempt deals, developers said. Spreads over LIBOR for construction loans on 9 percent low-income housing tax credit (LIHTC) deals were going for 175 basis points in September 2006. By September, developers were seeing spreads of 160 and in some cases 150 basis points over LIBOR.

On 4 percent tax credit bond deals, spreads on construction lines of credit had dropped to a range of 100 to 140 basis points over the index in September from a range of 150 to 175 basis points over the SIFMA index a year earlier. (Note: The Bond Market Association index is now referred to as the SIFMA index since the Securities Industry Association and BMA merged in November 2006 to create the Securities Industry and Financial Markets Association.)

Although construction financing may be more attractive now, the days of lenders offering looser covenants (borrower guarantees) are drying up, industry watchers caution.

Construction lenders have traditionally required two types of recourse: repayment guarantees (assuring that the construction loan will be repaid) and completion guarantees, which put the developer on the hook to pay for any cost overruns if the project is not built within a specified timeframe. In both cases, the developer would be personally liable if the guarantees were not met.

As the debt markets became hypercompetitive over the last few years, lenders were moving toward not only repayment guarantees that waived personal liability for the developer, but also toward completion guarantees that similarly eliminated personal liability for the developer.

That trend is expected to reverse. In 2008, “lenders will hold the line and insist on full recourse completion guarantees, but non-recourse on repayment probably will remain,” said Steven Fayne, managing director of Citi Community Capital.

The softened single-family housing market has brought several benefits to affordable housing developers.

Notably, more people have entered the rental market, making rent increases possible in most markets. This increase in projected income, coupled with a decline in land values in many markets in the wake of the subprime mortgage industry’s collapse, is making more deals pencil out.

And because banks are originating fewer single-family loans, they can make more capital available to multifamily developers. “Construction lending gives [banks] the security of real estate without the risk of single-family default,” said Sears.

Construction costs have stabilized in the past year to a point of predictability, developers said, especially as demand for key materials like copper, concrete, and steel diminish with a shrinking singlefamily market. As the cost of materials comes down, industry watchers are reporting more new construction deals pegged for 2008 than they’ve seen in years.

“For the first time in the last five years, we’ll be doing more new construction than acquisition/rehab deals in 2008,” said Fayne. “We’ve seen a 25 percent increase in the last five months.”

Established developers with long track records reported little or no change in spreads for construction financing of 9 percent LIHTC deals.

But for riskier deals, lenders are quoting on average a slight increase in spreads for construction loans on taxable debt. From the end of July to the end of September, those spreads widened by 20 basis points. Such deals will also offer lower loan proceeds and require more equity.

“Existing, repeat customers always get a little break on price and terms.” said Jay Helfrich, who heads the affordable debt-financing group for Alliant Capital/EF&A Funding. “Developers are more dependent now than a year ago on lender relationships.”