Post Covid – How Construction Finance Has Changed

Photo: Levelset

Written By: Teddy Swain, TRI Commercial Real Estate Advisor

Given all that is going on in the world today – Covid-19, shelter in place, record unemployment – it is now more than ever crucial that we continue to see the much needed affordable and market rate housing be built in the Bay Area. Cities and counties are still under pressure from state guidelines to meet the needed housing production thresholds despite a market that has been at a standstill for the last two months.

As things begin to open back up, it won’t take long for investors, builders, and developers to remember that the Bay Area remains one of the most underserved housing markets in the nation. To discuss how these projects can still get funded during this public health crisis I interviewed Vern Padgett, a 40+ year banking and finance veteran and colleague of mine at TRI Commercial.

Vern – I appreciate you taking the time today to talk over Zoom. Can you share a bit about your background in finance?

I started my career in business out of college back in 1977 as a management trainee at the Mechanics Bank. At that time the bank did engage in commercial real estate lending but it was typically activity in support of clients that the bank had worked with for multiple generations. It was a rather docile institution from a business development standpoint.

As I worked my way up through Mechanics Bank, I became involved more and more with CRE lending and eventually started the corporate banking division. We basically revamped the bank into a real estate industries group and a corporate banking group. I took over the real estate industries side as that was my specialty for several years and eventually left the bank in 2006. I was then a founding member of Presidio Bank and after that the Chief Banking Officer at Bay Commercial Bank. Eventually I left Bay Commercial to start Black Oak Ventures where we offer more creative bridge financing for borrowers who aren’t quite ready for the institutional lenders for whatever reason.

Let’s jump right in with two examples of spec housing development: an 8 unit condominium project and a 100 unit mid rise apartment building. Both are speculative housing developments but both have vastly different debt requirements. How are those loans typically funded?

The first, smaller project would be of interest to your local or regional bank and there are any number of those banks in the Bay Area that would be interested in funding those loans today.

For the larger loan you are going to look for somebody in the market that is looking to fund a larger deal. Wells Fargo is the knee-jerk option because they are probably the most active in that space. They are very fussy about who they lend to so you’re going to need to be a Wells Fargo client in order to get a Wells Fargo loan. Union Bank would also be a lender that may be interested as they are also a large player in that space. All these guys basically operate in a similar way; they have hold limits so they’ll do a $100MM loan but they won’t hold the full amount. They’ll participate out with bank partners so you may have a Wells Fargo originating the loan but they’ll have a ‘bank club’ and bring in say Union Bank, B of A, California Bank and Trust and they’ll spread the $100MM across their partners and keep the piece they want.

So essentially on the larger loans banks are spreading out their holding risk with a select number of bank partners?

Yes – that’s the business that a lot of these big lenders are in. They’re in the business of managing the big relationships, taking care of their client needs, absorbing the amount of balance sheet exposure that is best for them and shedding the rest to their bank participants. Loan demand isn’t high enough for a lot of the bank participants who try and originate their own deals and they don’t have the clients to fill their balance sheets. We are wash with liquidity right now, so as one of these banks you don’t want to be running at 60% loans to deposits because you don’t make any money, you want to be up around 80%, 90% or 100%. That’s why these partner banks are out there anxiously buying participations.

How has the underwriting for these loans changed given the trouble our economy is facing?

Well, there hasn’t been that much done in the last month and a half. Things have pretty much tamed down as people wait to see how things will play out but I’ve talked to a number of construction lenders recently who are still actively soliciting projects and have closed construction loans on the smaller type deals that we discussed. However, post Covid-19 the rules on those loans have changed: you need to be able to underwrite a hold on the loan as though you are going to hold the asset long term as an apartment building and cover it at a Debt Service Coverage on a 25-year amortization of that construction loan fully funded based on your proforma. Construction lenders today are looking to price their loans on an either or basis; say prime plus 1 – prime is currently 3.25% – so that is a 4.25% minimum rate but they probably are going to fix the floor at 4.5%. So, you can look at it as prime plus 1 or 4.50%, the higher of those two.

I would say that the underwriting metrics have been tightened down a quarter twist on the screw. Deals that would have been done at say 70% of retail value are now being done at 65%. So you’re seeing like a 5% cram down on the tightness of the underwriting. I think we still need a couple of months to see really where things will land.

We are currently in the midst of the pandemic; do you see lenders’ ability to fund construction loans like the two in our example continuing?

The answer to the question really depends on the product type and the track record of the sponsor. Retail development right now is somewhat radioactive so you’re probably not likely going to see much ground up retail development… for obvious reasons. Multifamily though is radically underserved especially in the Bay Area. It is very difficult to achieve entitlement for multifamily and the cities are under immense pressure from the state to fulfil their housing mandates and so I would suspect there will continue to be heavy demand as lenders like to see unfulfilled demand as a driver behind the reason to develop real estate. Not withstanding all the trouble that the economy is dealing with at large today as a result of COVID-19 and the SIP regulations; I can’t imagine that there will be any kind of long term interruption in that category from a lending standpoint.

There seems to be a shift towards pursuing business with existing clients rather than procuring outside clients that lenders may not have an existing relationship with, is this correct?

Yeah, it’s not as though we are in the midst of a go-go upcycle where banks are going to stretch to open up the doors to people who have very limited experience. People who used to work for a homebuilder and now want to BE a homebuilder are going to have a tough time. Those that have relationships and can demonstrate a successful track record in-line with the deal that they are trying to get approval for will still be able to find success today.

If you had to summarize our conversation into a few main takeaways what would they be?

I recently had a discussion with Bank of Marin regarding post Covid speculative for-sale residential product. Some of the key points that we discussed were:

  • The Bank maintains interest in the space and will lend a maximum of 70% of Bulk Sale Value (prospective completed value method), or 70% of documented Developer cash costs (the lesser of)
  • Will lend up to 18 months with a Coupon Rate to float at Prime + 1%, with Floor of 4.5% – 4.75% and a 1% Loan Fee plus all transaction costs for Borrower’s account
  • Release pricing on unit sales will be 125% of par, per unit, or 100% of net sales proceeds (the greater of the two)
  • Borrowers are to reflect solid successful track record with projects of a similar scope and complexity, with deep experience, demonstrable global liquidity, cash flow, and positive referrals from reliable sources.
  • Loans to be structured with full recourse to sponsorship via unconditional repayment guarantees with contingencies and contractor suitability is to be acceptable to Bank

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