While construction financing remains affordable, many capital sources are beefing up their underwriting criteria this year. Lenders are requiring developers to maintain higher levels of debt-service coverage, and even to put their own balance sheets on the line for new projects.

Developers are having their best success in finding construction financing through the regional and national banks, and even the Federal Housing Administration (FHA) has again become a viable source of construction financing.

Lenders’ newfound toughness on underwriting criteria marks a return to historical norms. Recourse has become a common feature on floating-rate construction debt after briefly disappearing at the height of the market’s frenzy, and debt-service coverage ratios (DSCRs) have risen in the first half of 2008.

“Recourse is again a big issue on construction loans,” said Phillip Carroll, a senior vice president of the Income Property Group of KeyBank Real Estate Capital. “Lenders are going back to where they were three years ago.”

In the fourth quarter of 2007, most of the regional and national banks—including Wachovia, Bank of America, and KeyBank—grew more conservative in the DSCRs of their construction loans.

In the fall, most banks were offering a 1.15x DSCR in strong metro areas like New York and Los Angeles, and a 1.20x DSCR in secondary markets. They have since moved to a 1.20x DSCR in primary markets, and a standard 1.25x in secondary metro areas.

FHA redux

As construction lenders grow more conservative in their underwriting, and less experienced borrowers have a more difficult time finding financing, the FHA has emerged as a more viable source of funding.

FHA-affiliated lenders have reported renewed interest in the administration’s programs among developers. “We attribute that largely to the credit crunch and tightening of underwriting standards,” said Nick Gesue, senior vice president of Lancaster Pollard, a member of the FHA’s Multifamily Accelerated Processing program. “The leverage you could get with the FHA, the debt-service coverage, and the non-recourse provisions, are more attractive than a lot of other finance options.”

The FHA’s flagship Sec. 221(d)(4) program features a 90 percent loan-to-cost ratio, a 1.11x DSCR, 40-year amortization, and is non-recourse. What’s more, developers can lock in the interest rate for both the construction and permanent loan at closing.

Borrowers were getting interest rates of around 6.25 percent to 6.5 percent for a Sec. 221(d)(4) loan in mid-April, down from as high as 6.75 percent last fall.

Affordable rates

In many ways, the pricing and underwriting of construction loans have followed the same trends that permanent loans are undergoing.

Although lender spreads have grown in the last year, the all-in rate for construction loans has remained stable in the first half of 2008, thanks to declining benchmark rates.

Rates on construction loans often float over the six-month London Interbank Offered Rate (LIBOR). The six-month LIBOR was at 2.72 percent in mid-April, compared to a 5.37 percent rate in mid-April 2007, and a 4.5 percent rate at the start of this year. This 265-basis-point drop has helped to keep construction loans affordable.

But lender spreads are widening. In November, typical construction loans featured spreads of between 160 and 200 basis points, but by mid-April, that figure had risen to a range of 220 to 300 basis points. Given a 2.72 percent LIBOR, the rise in spreads equates to an all-in rate of between 5 percent and 6 percent.

LIHTC focus

Developers working with low-income housing tax credits (LIHTCs) have other construction financing options. Boston Capital Corp., a longtime LIHTC finance company, issues construction/permanent loans for 9 percent deals through its Affordable Housing Mortgage Fund. The fund targets new construction or substantial- rehabilitation deals on which Boston Capital is the tax credit syndicator.

The loans are underwritten to Fannie Mae Delegated Underwriting and Servicing guidelines. Terms are typically for 20 years, featuring two years of interest- only financing for the construction phase and an 18-year permanent mortgage, which amortizes on a 30-year schedule.

What sets Boston Capital apart from similar programs, such as the FHA’s Sec. 221(d)(4) program, is the swiftness of its deal cycle time, the company said. “Certainty of delivery is key,” said Bill Fazzano, Boston Capital’s vice president of mortgage finance. “When somebody has to close a deal in 90 days no matter what, we can accommodate that.”

Boston Capital issues fixed-rate loans that lock the rate for both the construction and permanent phases of the loan. The typical rate is 235 basis points over the yield on the 10-year Treasury note, which at press time was 3.74 percent, making the all-in rate around 6.09 percent. The deals are underwritten to a 1.15x DSCR. The program is full recourse through the construction phase, and non-recourse once the loan converts to permanent.

The Richman Group is working on a similar program that combines tax credit syndication with construction/permanent loans, and some large banks, such as Bank of America, can offer a similar execution.

While construction financing has remained affordable, nobody knows how long the low LIBOR rates will last. Developers would do best to strike while the iron is hot, industry watchers say.

“One of the myths out there now is borrowers think they can sit on the sidelines and wait six, nine months for interest rates to get even lower,” said Keith Van Arsdale, managing director of BMC Capital’s Southwest Operations, at the recent APARTMENT FINANCE TODAY Conference in April in Phoenix. “But I’m not sure rates will get lower in that time. It’s probably going to be baby steps in terms of spreads coming down and underwriting getting more aggressive.”