Financing Construction In Today's Environment

It holds as true today as it did in 1992 when James Carville wrote it on the campaign headquarters wall: “It’s the Economy, Stupid!” The credit crunch has affected everyone, but few as hard as the real estate market.  No one knows what to value a building or a piece of land.  When valuations are not solid, lenders are uncertain as to how much they can safely loan to prospective borrowers.  Adding to the mix are the bank regulator’s increasing pressure in their examinations of the banks forcing them to tighten their lending standards.

The Wall Street Journal reported on February 8, 2008 that “The Federal Reserve’s latest survey of senior loan officers showed 80 percent of domestic banks tightened lending standards on commercial real estate loans in the past three months - the highest level since the question was first asked in 1990.”  Lending standards further tightened in the second quarter of this year.   According to the Federal Reserve Board’s July 2008 Senior Loan Officer Opinion Survey, standards on commercial real estate loans were tightened by 80 percent of the domestic banks that responded to the survey.  (Weaker demand for these loans also was reported). Net result - less (or no) money for real estate developers or real estate construction. 

Major money center banks, regional and community banks, and nontraditional nonfinancial institution lenders are taking a new and more conservative approach to giving credit.  The bottom line that a lender wants to see in a credit application from a developer or contractor is the wherewithal to make the monthly payment.  If you can demonstrate that the project will produce the requisite cash flow, you will have gone a long way to obtaining approval.  This means you have to convince the real estate appraiser for the lender that the property will produce the necessary cash flow.  (Some nontraditional lenders are taking a more proactive look at unconventional sources of cash flow to support their loans.)

The number 1 spot in the rankings is the vital “cash flow,” pushing other factors down on the consideration list.  However, it is some of the other more long-established factors that will influence an appraiser to project a better cash flow on a new property.  Of course, the traditional real estate truism is “location, location, location.”  For this purpose, location means not just the particular address, but also the economic and market conditions in the city and state where the property is located, etc.  Generally speaking, market conditions on the east and west coasts are better than in the middle of the country.  But cities that have good infrastructure and development, regardless of the state, may have a good economic outlook and that will influence an appraiser, and the lender.

Other major factors that an appraiser will consider is the class of building, and the leases and tenants.  It is much more likely that you will be able to generate a better cash flow from higher rents in a Class A building than from a Class B or Class C building.  Thus, it is likely that a lender will look more favorably on a project that contemplates a building with Class A amenities.  It is also more likely that a building able to retain its tenants and have a high occupancy rate will generate a more consistent cash flow.  If you are working on an existing structure, this is an important factor to examine.  If you have a high vacancy rate, try to determine and demonstrate why it is high, and describe what you are going to do to improve the situation; be it structural changes, common area improvements, better amenities, or something else.

The appraiser will make a careful review of your leases.  Are most of your tenants on long term leases, such as 5 or 10 years?  Stability works in your favor with the appraiser and the lender.  Are your rents “market” rents, or higher or lower than the surrounding market?  What are your recoverable expenses - Common Area Maintenance (CAM)?  Are you able to recover most or all of your CAM from your tenants?  Or do you have built-in caps in your leases that prevent you from doing so?  CAM can be critical to your cash flow.

You need to be sure that your leases are well drafted and provide for the maximum amount of recovery from prospective tenants.  While it may be argued that the market can limit what amount of CAM recovery can be bargained for, the difference may be in whether you are able to obtain the credit to allow for the project if you do not get your CAM back.  Proper drafting of your leases will also assist you in dealing with your tenants down the road.  The more questions that are answered up front in the documentation allow for fewer arguments later.  Fewer arguments lead to more satisfied, and more stable, tenants and, therefore, more stable cash flow.

Summary

Lenders do not want your property.  They want their money back, on time, with interest.  Given the uncertainty of the real estate market, lenders are not confident about what they can lend to give them that assurance.  Cash flow gives them the assurance.  If you are looking to finance work on an existing project, review the historical results and see where you can improve on them if need be to convince the lender that your project can pay for itself.  If you are looking to finance a new project, get your attorney and accountant involved early, and consider having your own appraiser complete a review to pull together all the information and documentation needed to convince the lender’s appraiser that your project will cash flow.