Introduction and Scenario Setup
In the world of real estate equity investment, there is much attention paid to the equity that needs to be raised to get a deal closed. While the equity piece is critically important, it doesn’t tell the whole story. In nearly all cases, it must be paired with some amount of debt to complete the capital stack. Yet, the parameters and requirements under which debt is obtained can vary widely from one lender to another, which can make a deal difficult to analyze. This post aims to change that.
This is the first in a series of posts on how a commercial real estate construction loan is underwritten, with a specific focus on how the underwriting requirements factors into the analysis of a private equity transaction. Over eight installments, we will set up a construction lending scenario and walk through how a senior debt lender analyzes the borrower, guarantor, sources of repayment, collateral, and market. In addition we will discuss key elements of the construction loan structure and common covenants.
This series is based on an actual construction loan request in a real estate equity investment transaction. Certain names and numbers have been changed to protect the confidentiality of the transaction, but all are based on the actual scenarios encountered.
Upon completion of the series, it is our hope that readers will walk away with a more nuanced understanding of the process, parameters, and requirements used by senior lenders to underwrite and administer a commercial construction loan. We will begin in the most logical place, with a broad discussion of the capital stack.
What is the Capital Stack?
In a commercial real estate transaction, the term “capital stack” is a colloquial reference to the collection of capital used to finance a purchase and/or construction project. Depending on the specifics of the deal, the capital stack can contain up to four parts and it is critical that every transaction participant understands each part and the rights that come with it.
The first tranche is senior debt. This is typically a loan made by a bank and it is the focus of this series of articles. It is considered “senior” because the holder is first in line to be repaid from monthly cash flow and upon sale or bankruptcy. To secure their position, the senior debt holder takes a first position lien on the collateral property. As a result, this is considered the least risky component of the capital stack and pays the lowest return as a result.
The second component is mezzanine debt, which is meant to fill the gap between the amount of senior debt offered by a lender and the amount of equity that can be raised by the transaction sponsor/private equity firm. The mezzanine debt holder’s claim to property cash flow and sales proceeds is “subordinate” to that of the senior lender, which means that they are only entitled to whatever is left over after the senior debt holder has been paid. Mezzanine debt can be secured by a second lien on the collateral property (less likely) or by an assignment of rents and cash flows from the collateral property (more likely). It is riskier than senior debt, which means that it also carries a higher interest rate.
In order of repayment, the next component of the capital stack is preferred equity. It is considered “preferred” because it is the most senior equity claim and the holder will be paid ahead of common equity holders. A preferred equity claim is not an investment in the collateral property itself, rather it is an investment in the shares of stock in the limited liability company that owns the property. Whereas as debt holders tend to have limited upside in a deal, preferred equity holders are typically paid some regular return plus some percentage of participation in the sale of the property. For this reason, the return tends to be higher than debt, which is necessary to compensate for the elevated risk.
Finally, the last component is common equity and the holder is last in line to be repaid. This makes it the riskiest position in the capital stack, but it also offers the highest upside because holders participate in the sale of the property. If it is profitable, the return can be significant.
So, it is against this backdrop of the capital stack that the construction loan request in this series of posts is made.
What is a Construction Loan?
While the definition of a construction loan may seem somewhat self-explanatory, many of the common features are not.
As the name suggests, a construction loan is senior debt that is provided to a borrower for the purpose of constructing a commercial real estate project. This loan type is unique in several ways:
- Proceeds: The proceeds of a construction loan are not released at the time of closing. Instead, they are released in “draws” that are based upon the percentage completion of the project. The number of draws is dependent upon the size of the project and the complexity of construction.
- Term: Construction loans have a relatively short term that is meant to span the length of time it takes to build the project, usually 12-24 months. Some construction loans may have a “mini-perm” feature, which extends the term for 3-5 years while the property is stabilized.
- Payments: The payments on a construction loan are interest only, which is meant to help the borrower conserve cash while the property is under construction. However, principal is due in full at maturity.
- Interest Reserve: More often than not, the interest payments are made from a pre-funded “reserve” account that is capitalized with proceeds from the loan at closing. The calculation of the reserve amount is dependent upon the total cost of the project, the timing of the draws, and the interest rate on the loan.
- Administration: Construction loan draws are not just advanced by the bank whenever they are asked for. Instead, there is a rigorous inspection process that is used to ensure funds are being used for their intended purpose. As such, they require a lot more administrative oversight than other loan types.
Construction loans are often customized for the deal on which they are made so the exact specifications and structure can vary from loan to loan. However, they all typically follow the same process.
How Does a Construction Loan Work?
The process of getting and using a construction loan usually involves five steps:
- Initial Discussions & Term Sheet: All loan requests start with a discussion between the lender and borrower. This discussion involves a broad overview of the project, the borrower’s needs, and the timeline for closing. If the conversation goes well, the lender may issue a Term Sheet, which is a general outline of the terms and conditions under which they may be willing to extend credit. It is not binding.
- Underwriting and Approval: If the parameters outlined in the Term Sheet are acceptable to the borrower, they will proceed with the request. In doing so, they are required to provide the lender with a series of documents including: project plans, budgets, tax returns, proformas, environmental surveys and appraisals (if they are completed). As part of their “underwriting process” the lender will review these documents and decide whether or not to approve the loan. If they do, they issue a loan commitment, which outlines the terms of the approval. It is binding.
- Closing: If the loan is approved and the borrower decides to proceed, all necessary documents are executed and the loan is closed. Remember, the closing of a construction loan does not mean that all loan proceeds are advanced to the borrower. Instead, the first advance at closing usually consists of the amount needed to pre-fund the interest reserve account and some nominal amount for a land purchase or other needs.
- Administration: This step is where the uniqueness of a construction loan shines. In order to obtain funding for each stage of their project, the borrower will request a “draw” from the lender. Each draw request details the line items in the budget from which funds will be advanced. Before approving the draw, the lender will send an inspector to the project site to ensure that the project is proceeding as described. If it is, the draw is approved and the funds are advanced. This process repeats until the construction project is complete.
- Maturity & Repayment: If all goes according to plan, the project should be complete around the same time that the loan matures, which means the borrower needs to repay it. In most cases, repayment of a construction loan comes from a permanent loan, sometimes from the same lender. If the project is delayed or the borrower is unable to obtain a permanent loan, they may need to request an extension and the lender will work with them on a case by case basis.
While the process is similar across different lenders, it is important to remember that not all lenders offer construction loans.
Who Makes Construction Loans?
The reason that some lenders don’t make construction loans is that they are administratively burdensome and require a significant investment in technology infrastructure and human capital. This is why private equity firms and real estate developers rely on longstanding relationships with construction lenders to get their deals done.
For the most part, construction loans are originated by large retail banks like Wells Fargo, Bank of America, BBVA, and PNC. Or, they are originated by specialized construction lenders like PlattPointe Capital or Broadmark Realty Capital.
Now that we’ve briefly discussed what construction loans are, how they work, and who makes them, let’s move into the REPE case study that is going to be the focus of this series of posts.
Construction Loan Scenario Overview
The intent of this series of posts is to describe how a construction loan is underwritten to fill the debt component of the capital stack in a private equity real estate development. Let’s start with the scenario.
Loan Request Overview
A medium sized real estate private equity firms are seeking $130MM in senior debt for the construction of a mixed use retail and residential condominium building located in the urban core of a major city in the southeast. This debt will be combined with a $5.5MM mezzanine loan and $45MM in equity raised from investors to complete the capital stack.
As with most private equity deals, the legal borrower in the transaction is a single purpose limited liability company formed specifically for the purpose of developing the proposed project. However, the transaction “sponsor” are the real estate private equity firms.
Sources of Repayment
There are two sources of repayment for the proposed construction loan: (1) Sales of the residential condominium units; and (2) rental income from unsold units (if necessary).
Collateral for the proposed loan is a first lien mortgage on 4.05 acres of land and all improvements thereto. In addition, the lender will be secured by an assignment of all rents, leases, and construction contracts.
The project is located in a residential neighborhood within the urban core of a major city in the southeast. The neighborhood is a fast growing one and is known for its walk ability, restaurants, entertainment, and proximity to a major park. Simply, it is the “hip” neighborhood in town.
These broad strokes of the construction loan request conclude this introductory post. In future posts, we are going to step through each aspect of the loan request and the detailed analysis that went into determining whether or not the loan was ultimately approved. These sections include:
- Borrower Analysis
- Guarantor Analysis
- Repayment Analysis
- Collateral/Project Analysis
- Market Analysis
- Structure & Covenants
Each one of these sections will be an individual post and will contain the detailed analysis that the lender used to determine the strength or weakness of the deal.