From SoCal Real Estate’s January 2019 issue:
Tips for winning at this tricky financing game
By Carrie Rossenfeld
It’s no secret that lenders are a bit reluctant to sign off on construction loans, particularly at this point in our long-in-the-tooth real estate cycle. Construction financing can be risky for lenders, who don’t want to get caught holding the bag if a project is delayed or doesn’t complete, so the onus of persuading lenders to put money behind new developments falls heavily on the borrower.
“Lenders are fearful of construction loans because of one word: construction,” Paul Rahimian, CEO of Parkview Financial, a private construction lender based in Los Angeles. “This word not only worries lenders, but worries others as well. The unknown in dealing with construction can create a pause with many investors and lenders.”
Simply said, lenders do not want to step in and complete construction projects — they are lenders, not contractors, and the risk of uncompleted projects creates a natural aversion, Rahimian points out.
The added worry and concern in Southern California are the escalating construction costs, he adds. “Unfortunately, costs in Southern California increased by a bigger number in 2017 than in any other area in the nation. This increase in costs creates another layer of risk and this leads to fewer approvals of construction loans.”
Fortunately, as with most aspects of business, there are tips and tricks for appealing to lenders so that construction projects put them at ease. Being realistic is the number-one way to insure a construction loan will get approved, Rahimian says. “Developers are optimistic in nature and tend to assume wage growth, rent growth, and cap-rate compression. In today’s world, where cap rates are at an all-time low, it is difficult to assume that cap rates will go any lower. And assuming wage and rent growth will continue in the foreseeable future is somewhat optimistic — it may or may not happen.”
Rahimian explains that lenders generally go with what might not happen and do not like to assume best-case scenarios. As such, assuming wage and rent growth (and higher valuations upon completion of a project) will inevitably lead to a rejection of a construction loan.
There are other things to avoid in order to up your chances of receiving construction financing. For one, borrowers should avoid predatory lenders, Rahimian says. “Not all lenders are created equal. Some lenders are truly lenders that want to create a yield for their bank, investors, and principals. However, there are some lenders that will take the risky deals and give the higher leverage — all in the hopes that the borrower will default and they can foreclose the asset. Borrowers can be intrigued by the higher leverage and lower rates, but they must be wary of this trap that could lead to a loss of their property.”
There are also certain types of construction that lenders are most comfortable doing business with and others that they are not, Rahimian adds. “Considering we are possibly at the height of the real estate market, many lenders are looking to close on income-producing loans so that there is a game plan in case of a market disruption. Retail is problematic with increasing vacancies due to shifts in the retail markets. Single-family residences are hard to lease out in the case of a foreclosure and will result in a very low yield. Land is most likely the worst asset type in a down market, as prices drop quickly and there is no way to produce a yield with vacant land.”
That said, the asset types that remain and are most comfortable for lenders in today’s world are industrial, office, multifamily, and hospitality, Rahimian says. “Industrial in Southern California is especially attractive as three of the top-10 lowest vacancies in the nation are Los Angeles, Orange County, and San Bernardino. Multifamily is attractive as it is easier to lease up vacant apartments in a market downturn.”
Even if you have the perfect project in mind, construction loans are becoming harder to close as we have a trifecta in the marketplace at this time, Rahimian points out: construction costs are still escalating (despite 48 months of escalations), interest rates are increasing at a rapid pace, and real estate valuations are at an all-time high. “This causes havoc for lenders trying to make sense of construction loans.”
The key to getting a construction loan closed is concentrating on quality assets with enough equity to give lenders the confidence to approve and close loans, Rahimian concludes. “High-leveraged loan requests in average or below-average locations or riskier asset types will be more prone to rejection in 2019 and 2020.”