Private lenders may have the solution for the sector’s ‘sweet spot’ projects
By Matthew Doerr, vice president
Chatter within the commercial real estate industry suggests we have reached, if not surpassed, the crest of the current market cycle, but the industrial sector is stronger than ever.
According to JLL’s 2017 industrial outlook report, vacancy rates on the West Coast are between 1 percent and 5 percent. With no signs of oversupply, or any economic, retail or logistical trends that point to a reverse in course, investors and developers continue to seek construction loans for industrial projects, while lenders remain open to working with commercial mortgage brokers and their clients within this space.
Industrial demand has unveiled attractive lending opportunities, especially given the sector’s abbreviated construction timelines. Quick completions allow borrowers to minimize whole-dollar interest costs on industrial-based construction loans, compared to an office or multifamily project of the same size.
Middle-market challenges
This demand for industrial space creates a win-win situation, right? Unfortunately, not for the middle-market industrial sector, in which construction projects range between 50,000 to 250,000 square feet and costs range between $10 million to $30 million. It is in this “sweet spot” where banks, brokers and borrowers have experienced increased execution risks, especially if they are seeking conventional leverage on a nonrecourse basis. In many cases, an apparent funding gap has formed as banks, brokers and borrowers search for creative ways to capitalize these projects.
Prior to the recession, banks were the largest source of nonrecourse construction financing. Today, they have returned to the market — albeit on a limited basis. Implementation of the final regulatory capital rules for institutions under the supervision of the Federal Deposit Insurance Corporation (FDIC), which took place in early 2015, caused banks to tighten lending standards, which led to increased execution risks for borrowers when securing construction financing, thus diminishing access to predictable capital solutions.
To mitigate risk, most banks are generally willing to provide nonrecourse construction loans at about a 50 percent to 60 percent loan-to-cost (LTC) ratio, and these terms may only be available to existing bank clients. If a qualified borrower is willing to provide recourse, the bank may increase the leverage up to 60 percent to 65 percent. Many developers simply do not have — or may find it too expensive to invest — 40 percent to 50 percent equity to complete the project capitalization and, consequently, seek a creative solution to meet their financing needs.
Borrowers may turn to a mezzanine lender to fill the gap between a bank loan and the typical 15 percent to 20 percent equity to complete the capital stack. Many mezzanine lenders, however, may find this type of structure unattractive because the mezzanine portion of the capital stack for a middle-market industrial construction project is about $5 million or less. For some lenders, this falls short of their targeted transaction size.
If a mezzanine lender agrees to provide a loan of this size, it would require an intercreditor agreement with the bank lender, which can result in a lengthy, complicated and often costly exercise for the developer. Further, intercreditor negotiations pose added risks for the developer and mortgage broker in closing a deal. Smaller mezzanine loans, when available, likely bear above-market interest rates and fees to offset the small transaction size.
High-volatility properties
In addition to the aforementioned nuances, banks may avoid lending on any projects classified as high-volatility commercial real estate (HVCRE) because of the increased loan-related costs they may face. For a loan to avoid being classified as HVCRE, the borrower must contribute at least 15 percent of the appraised-as-completed value of the asset before receiving bank financing, and the loan-to-value (LTV) ratio cannot exceed 80 percent.
“ Intercreditor negotiations pose added risks for the developer and mortgage broker in closing a deal. ”
There are very real situations, however, that may cause a loan or property to be classified as HVCRE that may not be immediately apparent. If a borrower has owned a piece of property for an extended amount of time, for example, or acquired it below the appraised market value, the actual cash investment is small and often far less than the required equity piece for bank financing.
Beyond the difficulty of securing funding from banks for middle-market industrial construction projects, many developers and brokers have witnessed a lack of predictability around HVCRE and have become reluctant to arrange capital from multiple sources.
Risks of partnership
There are qualitative and quantitative reasons why mortgage brokers and developers are reluctant to secure multiple sources of funding to meet the 80 percent LTC target for middle‑market industrial construction loans.
First, integrating two pieces of capital through an intercreditor negotiation increases the risk for deals to fall through because of senior-lender requirements that are often strict. A mortgage broker must tediously tend to the negotiation of multiple agreements that govern the partnership between the two lenders to ensure certainty of execution.
Furthermore, borrowers recognize risk that can potentially impact their business plan when securing a loan from two capital sources. The perceived lack of certainty of execution presents borrowers with heightened risk if:
Private-lender option
Regulations, tiresome negotiations and increased transaction costs have created an apparent barrier in lining up construction funding for middle-market industrial projects. Although obtaining capital for attractive industrial deals in a tight market can be challenging, some borrowers can find success if they turn to private lenders who are responsive and can provide custom solutions for a project.
For many mortgage brokers, opportunity may exist with the “one-stop shop” private lender that can execute the entire capital stack — minus borrower equity — and take a borrower up to 75 to 80 percent of the project cost with certainty of execution.
Within this framework, the cost of a nonrecourse construction loan from a private lender can be on par with the blended cost of a bank loan and mezzanine loan. This can be a win-win situation in which mortgage brokers are able to close quality transactions and borrowers can strike with flexible, nimble capital to accurately and swiftly respond to the healthy industrial market.
###
