“We are still finding attractive options for good projects where the economics pencil,” says Jeff Sause, director with capital services provider HFF. “There is money out there if you look hard enough.”
Bank lenders—the traditional source of construction capital—are offering smaller loans compared to the cost of development, when they offer to lend at all. However, other sources of capital can still fill the gap. Financing alternatives include life company lenders, private equity debt funds and the programs of the Federal Housing Administration (FHA).
“A number of insurance companies, private equity shops and specialty finance lenders have been quoting deals, and more groups are planning to start programs,” says Sause.
Banks and restrictions
Banks are still the largest player in the apartment construction market and they remain very active. But they aren’t willing to lend as much compared the value of the property. Banks that once made loans that covered up to 75 percent of development cost now only go as high as 65 percent. Interest rates are higher too, typically floating between 275 basis points to 325 basis points over LIBOR. That’s up from the low 200-basis-points range earlier in the recovery.
Banks are less willing to lend partly because of new regulations that require them to keep cash in reserve to offset risky investments like real estate construction loans. The regulations include international rules like the Basel III and U.S. laws like the Dodd Frank Financial Reform law. “The amount of construction loans being arranged in this market is down substantially,” says Mitchell Kiffe, senior managing director with CBRE Capital Markets.
Lenders of all types are also growing more cautious as more new apartments open and vacancy rates begin to climb in many markets. Many lenders already have construction loans that are not performing as well as expected. “Absorption is more challenging,” says Kiffe. “Pro-forma estimates are maybe not being achieved. Lenders are looking carefully at all their new loan applications.”
Where to look for financing
New sources can help developers find the money to build. “As banks face higher regulatory scrutiny and capital requirements due to Basel III HVCRE standards, non-bank lenders are entering the market with more ease,” says Justin Bakst, director of capital markets at research firm CoStar.
Private equity debt funds can provide construction financing for apartment properties—at a price. The cost of this capital may be twice the interest charged by a bank lender for a loan that covers 55 percent to 65 percent of the cost of construction, with floating interest rates from 600 to 700 basis points over LIBOR.
Borrowers can also combine a lower leverage bank loan with mezzanine financing, often provided by a debt fund. The financing package often covers a total of 75 percent to 80 percent of development costs. But the interest rates charged by mezzanine lenders are often as high as 12 percent to 13 percent. Many banks also refuse to make construction loans in combination with mezzanine financing. “Many banks are not comfortable with mezzanine debt,” says Kiffe.
Life companies also provide construction financing. However, they tend to lend to very high-quality apartment projects, which may already have a lot of financing choices. Borrowers that receive life company financing may also have to commit to a construction loan that is merged with a permanent loan, with a long, 10-year combined term and a fixed interest rate.
“Life companies want longer duration assets,” says Kiffe. That’s not always a good fit for merchant builders that may plan to sell their developments after they are stabilized.
Meanwhile, borrowers with time to spare may also turn to construction financing provided through the programs of the FHA. These loans typically offer low interest rates, but can take as long as six to nine months to close once a potential borrower submits an application.