Structuring a construction loan can be a tricky proposition, with developers wading through a sea of legal language fraught with potential pitfalls and hidden costs.
While the largest affordable housing developers often wield diverse resources to seamlessly guide them through the process, less experienced smaller and mid-sized developers may see their projects come apart at the seams based on how the loan was structured.
We asked some of the top affordable housing developers, including The NRP Group, Volunteers of America, and McCormack Baron Salazar, to identify best practices as well as some of the pitfalls developers often experience.
Read it, and read it again
One of the most common mistakes developers make when negotiating a construction loan is also one of the most avoidable. “Developers sometimes simply don’t read the loan documents,” said Robert Gibson, a financial analyst with Volunteers of America. “You tend to think that they’re all cookie-cutter, and it’s just standard legal language, but there’s always going to be a lot of business terms in there.”
Every lender has a different way of putting loan documents together—some lenders will have 30 different agreements as part of the overall construction loan, while others may condense the language to five documents. “Every document is equally important and every document tends to cross-reference itself, so it’s important to be very detailed in terms of understanding what you’re agreeing to,” said Gibson.
Developers would do best to hire legal counsel, but relying on lawyers too much can lead to another pitfall, one that taught Volunteers of America a valuable lesson early on. “The attorney is going to read it for legal terminology, but the attorney may not be reading it for the business points of the deal,” said Tom Turnbull, vice president of financial services at VOA.
“In our early stages of development, we had a number of documents that our attorneys thought were fine, and then when we got them in the business office, they had deal points that were very difficult for us to live up to,” Turnbull said. “After the fact, there’s very little you can do.”
Underestimating the task at hand—not asking for enough money—is easy to do, especially considering that the smaller the loan the more likely it is to be approved. However, you can’t put a price on the value of sizing the debt right the first time.
The best possible case shouldn’t be the scenario a developer structures its budget around. “It’s a lot better to be realistic in putting together your budget assumptions, and not [use] the best case in terms of how quickly you could get it done if there were no weather delays, for instance—because it just doesn’t happen,” said Kevin McCormack, president of developer McCormack Baron Salazar. “You need to build that time in.”
Timing is everything. Construction loans are moving targets, contingent on the timing of the permanent financing. Not allowing enough time for the construction phase to finish before the permanent loan is scheduled to start is a common stumbling block.
“If you have a commitment that says you must deliver a permanent loan 18 months from now, and that you need 90 days of stabilized occupancy of 90 percent plus, that means you need to be completely leased in 15 months,” said McCormack.
Paying a premium to extend the permanent commitment may be prudent in some cases. “Maybe what you need to do is talk to the permanent lender, and [end up] paying a little bit more, getting a commitment that runs out to 21 months,” said McCormack.
Reallocation of funds
Flexibility is a key feature of any construction loan, so much so that experienced developers often will pay a premium to ensure some wiggle room. “There’s a certain amount of flexibility we like to have with our construction lenders so that if an issue arises, you’re not stuck in a box,” said Andrew Tanner, vice president and CEO of The NRP Group, an Ohio-based affordable housing developer. “We’ll pay more to work with those particular lenders.”
If construction costs rise during the construction phase—a common enough malady in the last few years—and the developer needs to go back to the lender for more funds, it’s best to negotiate that flexibility up front. “As long as you have the sources to pay out the cost of the project, the lender should be willing to increase the size of the loan if you need it,” Tanner said.
Having the ability to reallocate costs in the loan document also is key. Because costs can and will change, developers should build in a mechanism for getting the lender to reallocate funds to other aspects of the construction budget should the need arise. “Being able to reallocate costs between line items, and being able to do it fairly easily, is important,” said Gibson.
Another important flexibility consideration is structuring a “cure period” in the loan document, so that if the unthinkable happens and the developer goes into default, “a lender is providing notice that you are in default and you have time to fix the problem,” said Tanner.
Developers also should watch out for add-on fees from the lender that may seem small individually, but can snowball in the final tally.
The developer may not notice some less obvious add-on fees early in the process. Line items like high due-diligence fees, and administrative or processing fees can easily take a back seat to the larger loan terms.
Legal fees, heaped on top of what the developer already is paying its own attorney, can be another overlooked cost.
“The developer may not realize that a lender’s going to charge them $30,000 or $40,000 at closing for the legal work associated with the construction loan,” said Gibson.
Developers must balance the need to strike close relationships with lenders, with the need to have enough lender options to find the best deal.
“You want enough so that you’re keeping everyone honest in terms of pricing, but you want the relationships so that they are also willing to work with you when things don’t go exactly as you expect,” said Tanner.
It’s difficult to understate the need to strike a good relationship with a lender. “Don’t spread your business too thinly,” warns McCormack. If lenders go to the time and effort to understand and develop business with a developer, “don’t keep shopping each new deal to someone new,” he said.
If a competing lender is 25 basis points cheaper on the interest rate of a $5 million loan that will be paid down evenly over a 16-month construction period, for instance, the cost in terms of your relationship with your usual lender may not be worth paying to achieve the financial savings.
“When you finally figure out what that number is, it’s not worth trying to overly negotiate that piece, because it’s only a few thousand dollars,” McCormack said.
Instead, putting emphasis on developing a relationship with your lender could pay dividends, “especially when times aren’t that great and they’re rationing what they’re doing, and you’re one of the people that they’re doing something with,” McCormack said.