Leveraging Construction Financing: The ins and outs of finding the right loan.
Recently, Spinell Homes completed the thirteen-lot Woodhaven Preserve subdivision near O'Malley Road and Huffman Road and the 79th Street GarageTown facility at the corner of 79th and Petersburg. Both Anchorage projects were financed through Northrim by Spinell Homes or the subsidiary 79th Street GarageTown--although Woodhaven Preserve was done with minimal financing due to cash on hand at the time of development. Spinell Homes also just closed on a land purchase and development loan that was used to buy the land and build the roads of Phase 9 of The Terraces Subdivision. The company anticipated beginning construction in August.
Who's Receiving Financing and Why
Construction financing is critical to helping companies like Spinell Homes complete new projects in Alaska. Project owners are also using construction financing to facilitate major remodeling projects.
For example, First National lends money for the construction of commercial buildings for owner-occupied use and also investment property. The bank works with a wide variety of partners, such as the Small Business Administration, United States Department of Agriculture, and Alaska Industrial Development and Export Authority, to provide the best financing options for its customers, according to Assistant Vice President and Loan Officer Ligia Lutan.
The construction loans that First National facilitates are driven by the private sector and range between $1 million and $25 million. The funds are used equally for new construction and remodeling.
Today, construction loans are a common tool for many developers and owners of commercial projects. Typically, developers like to obtain funds to bridge the time between realizing expenses and obtaining revenues. The key reasons that borrowers prefer to finance construction projects are limited cash reserves and low interest rates. Substantial costs are incurred during construction, and financing can alleviate the situation. "After the land purchase, planning, and design, cash can be depleted significantly, requiring bank financing," Lutan says. "Only after the construction is completed and stabilized do revenues begin and cash will flow."
However, Lutan points out that Alaska's commercial and institutional builders--those who primarily erect schools, office buildings, malls, and warehouses--are highly sensitive to state government spending and the capital budget in particular, which help fund new construction and repairs to existing buildings, utilities, and vehicles. They're also sensitive to the economy. "Due to Alaska's recent recession, we saw few, if any, large construction projects cropping up in Alaska," she says. "Most construction activity has been comprised of projects in the middle-market range such as senior housing projects, low-income housing, and refurbishing of older structures for modern office use."
Lutan adds: "The construction industry is a market-driven system, and financing for construction projects goes hand in hand with it. It is clear that Alaska has experienced a significant economic downturn and further uncertainties will continue through 2018."
In general, the demand for new construction financing is definitely down from a few years ago, says Wells Fargo Alaska Commercial Real Estate Manager Patti Bozzo. Wells Fargo provides construction financing for a variety of commercial projects, including office, warehouse, and multi-family housing. Typically, the bank's commercial construction projects encompass "ground-ups," tenant improvements (for extensive renovations or conversion from one use to another), and affordable housing low-income tax credits.
Bozzo says a mixture of borrowers seek financing for their projects, from Native corporations to developers constructing medical offices to retail establishments mostly renovating existing buildings. While entities like Providence Health or Walmart generally don't source traditional financing for construction projects, the average developer is prone to secure some type of financing. "It's good to use a bank loan, as opposed to their own cash," Bozzo says. "They feel they can get a good return by borrowing money."
Incidentally, when it comes to a construction project, a developer can wear one or two hats. Construction developers can be just project owners or both the owner and contractor of a development project. in the construction industry, a developer is usually considered to be a person who develops land through construction and who, to this end, becomes an owner of the developed land. The developer seeks a profit from the development of the land, either by selling a development--such as a tract of residential homes, a shopping mall, or an office building--or by holding the developed property to reap a return on the investment.
For the right terms on a loan, developers and business owners will often borrow money to facilitate their project, Bozzo says. That describes the situation with Todd Nugent, president of Howdie, Inc., a mid-size commercial general contractor who also offers development services primarily in the booming medical industry. As a developing contractor, Nugent often obtains construction financing to help limit his funding into a project. He says: "The less cash the developer and owner has in a project, the better return on the investment... It's not that we don't have the cash available, it's just that we're looking for a higher return."
That's why Nugent sought financing to construct the two-story, 28,000-square-foot Meridian Park Medical facility in Wasilla. Completed last fall, the $7 million project was financed by Wells Fargo with a twelve-year loan at less than 5 percent interest. Nugent received "mini-perm" financing that automatically converted to a permanent loan, so only one loan was involved. He used the funds for 75 percent of the total project costs, which included site acquisition, building construction, and site improvements.
Wells Fargo's financing was important to completing a successful project. "Without a construction loan, the return on cash would not have supported a reasonable lease rate," Nugent says.
Today, leasing is going well. As of early August, the medical office building had just 3,000 square feet of shell space available for tenant improvement.
Low interest rates have helped make financing reasonable for Connie Yoshimura, the owner/broker of Dwell Realty. In her last development project three years ago, Yoshimura received financing for land acquisition and horizontal development (for roads, water, sewer, and storm drains) for the Huffman Timbers subdivision. The South Anchorage project, located at Huffman Road and Lake Otis Parkway, featured forty-three lots, which have since been filled with energy-efficient, craftsman-style homes. "We would not have been able to complete the project without the loan," Yoshimura says. "It was always our intention to finance the land and horizontal construction."
Having worked in residential land development for twenty-plus years, Yoshimura has witnessed significant changes in the industry. Some of these changes have not been positive. She explains: "Today the only people who should be in residential development are people who own the land or builders who buy land. At this particular juncture, there is no profitability in being just a residential land developer who buys the land, puts in sewer, water and roads, and puts lots up for sale. You have to own the land freeand-clear... It's not profitable if you have to pay fair market value for a piece of dirt."
As a general observation about construction financing, Spinelli emphasizes that local companies that offer financing tend to rely on local boards and committees when making decisions. This is important in Alaska, he says, because sometimes the local economy does not make sense to a loan committee in Texas. For example, when the housing bubble burst down south, Spinell Homes wound up losing its longtime source of construction financing. "What followed was an extremely stressful eight-month scramble until we could shift our financing to Northrim, which is now the best relationship we have ever had with a bank," Spinelli says.
However, he says, almost more important to the business of selling houses is the long-term financing that buyers receive. Spinelli explains: "Without this, 1 doubt many people would be able to save enough money to purchase a home, thus reducing our customer base and our total output drastically."
How the Loan Process Works
A construction loan can be granted to fund all or part of the soft and hard costs required to build and otherwise develop a new project. Often the borrower will be required to inject 25 percent to 30 percent of the overall cost. Equity in the land can reduce the out-of-pocket cash injection.
The construction loan process begins when a developer or a business owner submits a request for a loan, Lutan explains: "During the underwriting process, we will evaluate the proposed project's viability by looking at the following elements, among others: the construction budget, the local market conditions, the development team, and financial capacity of the guarantors. We also generally review and evaluate any other risks inherent in the loan request."
Typical documents required in the underwriting process include borrower/guarantor tax returns, financial statements, a schedule of real estate owned and contingent liabilities for the guarantor(s), the proposed project's pro-forma, construction loan sources and uses, cost estimates, full project plans, engineering specifications, and, in general, any other documentation that can support the loan request.
The credit approval process is similar to other commercial loans, but because of the additional risks inherent in construction loans, further consideration is given to the development team and general contractor, as well as the prevailing market conditions. Upon completion of underwriting and approval, a loan then moves into the closing process, which can take on a life of its own. Commercial construction loan closings are complex and involve a large quantity of documentation, Lutan says.
A construction loan can be granted to fund all or part of the soft and hard costs required to build and otherwise develop a new project. In almost every construction loan, the borrower uses the land and proposed building as collateral. And depending on the project, land may be a bigger portion of collateral. "Almost always, lenders will require the owner(s) to provide personal guarantees, wherein they agree to personally pay back the loan should the project run into insurmountable obstacles," she says.
Traditionally, two loans are required to finance a real estate development project: short-term construction financing and long-term permanent financing. Short term financing funds the construction and lease-up phase of the project. After a project achieves "stabilization" and leases up to the market level of occupancy, the short-term construction loan is paid off by the long-term financing.
Sometimes, these two loans can be combined into one for the borrower's convenience. This is known as a construction to permanent loan, which is the type of financing Nugent received for Meridian Park Medical. "This option allows the construction loan to automatically convert to the permanent financing terms upon construction completion and stabilization, depending on the use of the property," Lutan explains.
During construction, loan funds are disbursed in direct proportion to the percentage of completion after project inspections and certification of draw requests. In most cases, the borrower will make interest-only payments during construction--meaning, once construction is complete, they will pay the full principal amount of the loan plus the interest. "The faster the construction is completed, the less interest they will have to pay," Lutan says.
Like First National, Wells Fargo has a detailed method for processing construction loans. In addition to collecting all the appropriate financial information, Wells Fargo closely scrutinizes the project sponsor or owner of the property being built. "We look to see if they have the financial strength to cover cost overruns or other issues during the building process," Bozzo says.
Wells Fargo also evaluates the contractor to determine if he or she has the financial resources to meet the inherent obligations. It's ideal to choose a general contractor who is reputable and can provide a fixed-price contract where an amount is stipulated for the work to be done. This can help minimize the risk of cost overruns--and the risk to the bank.
Typically, Wells Fargo uses a single-close or advancing term loan. The construction financing piece and a permanent loan are underwritten at the same time, so that there is one loan.
A Distinctive Type of Financing
Construction loans are distinctive from other types of commercial financing in a number of ways. The biggest difference is the risk associated with construction financing because unexpected things can happen. "You don't always know what you're going to get as you start your project," Bozzo says.
Lutan of First National agrees. From a lender's perspective, a construction loan is a short-term and high-risk investment. To help mitigate this risk, lenders follow firm procedures to ensure there is a reasonable relationship between the outstanding loan balance and the value of the collateral. "First National usually also requires the construction loan borrower to provide, in advance, a permanent financing commitment issued by us or another lender, stating that a loan amount will be funded by the permanent financing lender by a certain date after the construction is completed."
One of the most notable differences between a commercial construction loan and other types of commercial financing is that with a construction loan there is no operating history to analyze and factor into the loan decision. "The economics of the project, and thus the valuation of the property, is based solely on the real estate pro-forma projections," Lutan says.
Commercial construction financing is also more complicated than standard business loans. That's due, in part, to the required documentation, combined with close and consistent monitoring of the project. "Due to their multiple-stage nature, and the sometimes [unpredicatble nature] of construction work, commercial construction loans can quickly become complex and difficult to underwrite and secure," Lutan says. "But understanding how construction loans work and how commercial developments are evaluated can help streamline the construction financing process."
By Tracy Barbour
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|Comment:||Leveraging Construction Financing: The ins and outs of finding the right loan.(FINANCE)|
|Publication:||Alaska Business Monthly|
|Date:||Oct 1, 2018|
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