Guest Viewpoint: Why are Commercial Construction Loans Inherently Risky?
Robert Withers | November 2018
Too often, developers can’t secure permanent financing upon a project’s completion. If it’s a condominium project will the condo project sell out? Then, there is construction gamble, as cost overruns, accidents, delays and other problems tend to occur on every job. Imagine, for example, a crane falling or dropping an expensive beam. Further, good labor is harder and harder to find these days—and I predict that you’ll see more labor slowdowns as workers demand higher pay.
And that’s just scratching the surface. Politics play a huge part in the construction universe. A government employee might put a last-minute kibosh on your project. Perhaps, the City Council increases the parking requirement at the last moment. Then, there’s the marketing risk. Are the condos you are building actually going to sell at their projected sales prices? Will your new office space lease at your pro-forma rents?
Let’s face it, a million things can, and do, go wrong on commercial construction projects. You’ve been there, right? As a result, banks are demanding tremendous equity in their construction deals. During the go-go days before the dotcom meltdown, banks routinely made commercial construction loans of 90% loan-to-cost. Many people got slaughtered when commercial real estate collapsed by 45% after the dot-com stocks crashed.
Commercial construction loans, it should be noted, are almost always made by commercial banks. The rare exception? Life insurance companies occasionally make construction loans ($20 million or higher) on such properties as office towers or shopping centers. In general, commercial banks make commercial construction loans because construction loan terms are short—typically 12 to 18 months—and the bank earns its fees and points upfront.
Eight years after the dot-com crash, the commercial real estate market recovered, and banks were making commercial construction loans of 80% loan-to-cost. The sub-prime mortgage crisis then struck, and banks once again took a beating in commercial construction lending.
In the wake of the Great Recession, banks regulators really clamped down on commercial construction lending. Loan-to-cost ratios in excess of 70% were strongly discouraged.
Aggressive commercial construction lending has never quite recovered and has yet to return to pre-crash levels. The good news is that a few banks are once again making construction loans 75%-80% loan-to-cost. This still requires that the developer contribute a whopping 20%-25% of the total cost of the project. That said, under the JOBS Act, it is easier to raise equity dollars these days.
Private equity real estate financing is playing a larger role in financing these projects. From the smaller builder to larger national developers, these entrepreneurs are depending more and more on alternative lending sources to “put the shovel in the dirt” for their projects.
In an article I authored earlier this year “The Role of Alternative Lending in the CRE Market Today,” published in the February 2018 edition of Real Estate In-Depth, I referenced the role of alternative lending sources in the overall makeup of national lending activity has increased dramatically in recent years. These lending sources rely less on the bureaucracy-laden models of larger, commercial lending entities and operate with a more entrepreneurial, real estate-centric philosophy to achieve funding for these types of deals.
I personally see the role of these lenders growing over the next few years as commercial banks and insurance companies cut back their exposure to commercial and investment construction loans.