Navigating Construction Loans, Part 3

In the final installment of this series, Avison Young Principal Jay Maddox addresses some of the challenges unique to the financing mechanism.
Jay Maddox

The first two parts of this series highlighted how lenders structure construction loans to mitigate the inherent risks, the guarantees that lenders typically require, and how borrowers can best protect their interests throughout the lending process. This final part will detail some of the challenges of this particular note in today’s market.

Capital is Abundant

Commercial banks have traditionally been the leading providers of construction loans. However, they have been constrained by regulations adopted after the Great Recession, most notably the capital requirements for so-called high-volatility commercial real estate (HVCRE). In response, quite a few private loan funds were established to fill the gap vacated by the banks, offering bridge loans with more flexibility and greater proceeds. As competition has intensified, the loan funds have gradually expanded from offering lower-risk bridge financing into higher-leverage/higher-yield construction lending. At the same time, a number of private equity funds that were traditionally providers of joint venture equity for new developments and value-added projects also established high-yield lending platforms. For larger projects, the loan funds will occasionally lay off a low-risk senior piece to a commercial bank, which has enabled the banks to continue to participate in the market while earning attractive risk-adjusted returns. The result of all this capital formation has been that funding for development, construction and “heavy lift” value-added projects is abundant. 

The market shows signs of peaking

Despite the current availability of capital for construction projects, there are some signs of increasing caution due to a perception that we are at or near a cyclical peak in valuations. We have already seen a steady 10-year increase in commercial real estate values in most markets, and valuations in many cases are at all-time highs. Unemployment is at historical lows, economic growth is robust and both wage growth and inflation seem to be picking up. There is also increasing anxiety about the impact of trade wars with China, in particular, as well as ever-increasing government debt and deficits.

While underlying fundamentals are still strong in many markets, some lenders are increasingly concerned that they may be funding a project at exactly the time the market is slowing down or possibly tanking. A variety of factors gives rise to these concerns. Rising short-term interest rates have had a direct impact on project costs since construction loan interest rates are typically tied to the 30-day Libor index. Rising long-term rates will probably be followed by rising cap rates in 2019 and 2020, which could affect valuations if rent or NOI growth slows.  Additionally, construction costs have been increasing faster than rent growth in most markets, and some cost categories have seen double-digit cost inflation. 

The construction lending outlook is positive

The availability of construction financing should remain good in 2019, especially for experienced developers with solid projects in gateway markets with strong demand fundamentals. However, given the concerns raised above, we can expect to see more conservative underwriting which could result in higher equity requirements for borrowers. In particular, lenders may require more cushion in the event of cost overruns or delays in lease-up. Also, the already lengthy lead times to complete a project’s construction financing requirement are likely to be even longer as lenders will be more selective.