Underwriting a Construction Loan – Borrower Analysis

This is the second post in our ongoing REPE Case Study on how a real estate private equity construction loan is underwritten by potential lenders.  This installment will focus on borrower analysis.  If you haven’t had a chance to read the first post, you can do so by clicking here.

The intent of this article is to describe:

• What a borrower is
• What a lender is looking for in a borrower, and
• What sort of analysis they conduct to ensure the borrower represents an acceptable risk.

By the end, readers will have a greater understanding of how borrower analysis is conducted and should be able to incorporate this knowledge into the day to day tasks of their real estate private equity careers.  To jump directly to the recap section, click here.

What is a Borrower? 

It may seem like a no-brainer, but the definition of a borrower carries an important legal distinction in a construction loan.

Technically, the borrower is the individual or entity that is legally responsible for repaying the construction loan.  Most real estate private equity transactions are conducted through a “single purpose entity,” which is formed specifically for the purpose of building and managing a commercial real estate asset.  When the investment is complete, the entity is dissolved.

Because the entity does not have any assets or liabilities, there isn’t really anything for a lender to analyze as part of their borrower analysis.  As a result, they will typically rely on the transaction “sponsor” that is behind the loan request.  This would be the private equity firm and/or the individuals behind the request for the REPE firm.

What is the Lender Looking For in a Borrower?

A lender’s main priority is to protect their capital.  As a result, they invest a significant amount of time to make sure that they understand every aspect of the borrower.  While the specifics can vary from deal to deal, borrower analysis typically focuses on the following points:  

• History & Experience:  Does the borrower and/or sponsor have a history of success with the type of project that they are requesting a loan for?  Can they demonstrate this with successfully completed projects or projects under construction?
• Principals and Qualifications:  Do the principals of the transaction sponsor have the qualifications needed to execute the proposed project?
• Projects Under Development:  What projects does the sponsor currently have under development?  Are they similar to the proposed project?  Will they distract the borrower from completing the proposed project?
• Financial Strategy & Investment Approach:  What is the strategy and approach that the sponsor uses to construct and operate their commercial real estate assets?
• Business Plan & Geographic Footprint:  What is the sponsor’s business plan?  Is the proposed project consistent with it?  
• Lenders and Sources of Equity:  What other lenders does the borrower/sponsor work with?  Where are they getting the needed equity for the proposed transaction?
• Borrower Structure:  What is the legal structure of the borrower?  If it is a Limited Liability Corporation, who are the major shareholders and what is their relationship to the sponsor?

The bottom line is this, the lender’s job is to look at every aspect of the borrower/sponsor to make sure that they have the experience, track record, and expertise needed to construct the proposed project and repay their loan as agreed.  Let’s see how our case study sponsor stacks up against the above elements. 

Request Recap

As a quick recap, the loan request is from a medium sized private equity firm who is seeking $110MM in senior debt for the construction of a mixed-use retail and residential condominium building located in a major city in the southeastern United States.  With this in mind, details on the borrower/sponsor are provided below.

Remember, this is an actual real estate private equity transaction, but details have been anonymized to protect its confidentiality.

Borrower Analysis

Who Is The Borrower/Sponsor?

The legal borrower in the transaction is a single purpose entity formed specifically for the purpose of constructing the proposed mixed-use project.  It is a limited liability corporation and, at the time of the loan request, it has no assets or liabilities.  As a result, it is necessary to rely on the transaction sponsor for analysis.  For the sake of this post, we will refer to the firm as ABC Private Equity.

What is the Borrower’s History & Experience?

ABC Private Equity is a mid-sized private equity firm with 30 years of operational history.  It was founded by a European business executive who moved to the United States to launch the firm.  The initial focus was on the southeastern United States due to its growing population, strong job growth, and good weather.  While the firm’s initial focus was on land, residential, and office properties, they soon shifted their focus to concentrate specifically on multifamily assets.

In the three years prior to the loan request, ABC Private Equity successfully converted several existing multifamily rental projects into condominiums and has several more in progress.

Pros:  This is a clearly experienced transaction sponsor with a multi-decade track record of operational success.

Cons:  Their current focus is on apartment to condo-conversions, which is a different product type than the one they are looking to construct with the loan proceeds.

Principals & Qualifications

The project will be overseen and managed by three senior executives at ABC Private Equity:

1. CEO:  The CEO of ABC Private Equity Corp is a major shareholder and responsible for the firm’s day to day operations.
2. CIO:  Given the scale of the project, the Chief Investment Officer will also be personally involved in the oversight of the project.  He has been with the firm for 20 years and has overseen $300MM in completed projects. 
3. Development Manager:  Finally, a senior development manager with the firm has been assigned to run the project.  He has been with the firm for 10 years and will be responsible for day to day management.

Pros:  This is a strong management team as evidenced by their significant experience and long duration of employment with the transaction sponsor.

Cons:  While the principals are very experienced and will be involved in the deal, the primary point of contact is a more junior level employee who is less experienced and may not have the authority to make big decisions on the project.

Projects Under Development

At the time of the loan request, ABC Private Equity has four projects that are under development.  They are detailed in the table below:

In addition to the four projects under development, the sponsor is also currently managing 30 other apartment complexes.

Pros:  Clearly, the sponsor has been able to leverage their experience into multiple projects, which could bode well for their future profitability.

Cons:  It is good to be busy, but it can distract the sponsor from the project that they are attempting to finance.  In addition, they have a significant amount of capital invested in those projects, including guarantees of debt.  These are known as “contingent liabilities” which means that if one of those projects goes bad, the capital needed to support it could impact the sponsor’s ability to support the subject loan request.  This will be discussed further in the repayment section.

Financial Strategy & Investment Approach

This is where it can begin to get complicated because a REPE deal often involves several entities, each of whom are responsible for some share of the project’s cost.  This deal is no exception.

Although the project is owned by a single asset entity, it is controlled by another wholly owned subsidiary of ABC Private Equity Corp.  The financing strategy/capital stack for the proposed project is as follows:

The project’s senior debt of $110MM will not exceed 80% of its “as complete” value and this will be financed by the proposed loan.

Through other entities and individual investors, ABC Private Equity Corp will contribute 17.5% of the project’s cost in equity.

The gap between the project’s total cost and the combination of senior debt and equity will be financed by a mezzanine loan that will be secured by shares in the controlling entity. 

Beyond this capital structure, ABC Private Equity has negotiated a fixed price construction contract that is fully bonded with an experienced general contractor.  In addition, they have guaranteed the borrowing entity that the project will be completed within a specified budget.  Once the project is complete, ABC Private Equity Corp will not be subject to any additional capital calls and any operating deficits will be the responsibility of the limited partners in the deal.

Pros:  A fixed price construction contract limits the risk of cost overruns.  In addition, the borrowing entity – through their subsidiaries and limited partners – is injecting a significant amount of their own capital into the project, which is a good indication that they are financially invested in a successful outcome.

Cons:  The existence of mezzanine financing raises the risk profile of the transaction.  It also complicates matters by involving another lender who will certainly have their own opinions, requirements, and approval criteria.

Business Plan & Geographic Footprint  

From the “Project Under Development” section, we know that the sponsor has four projects under development and currently manages 30 more.  This approach is consistent with their business plan.

The sponsor’s business plan is to target urban/infill sites in the fastest growing cities of the sunbelt.  However, their typical product is rental apartments and this request represents their first foray into “for sale” condominiums, but it won’t be their last.  Given rising housing prices and demand for urban locations, this is the beginning of a longer term shift to for sale condos and rental to sale condominium conversions.

Their research shows that shifting demographics and changing lifestyle preferences point towards the convenience and flexibility of urban, walkable locations.  They believe this trend will continue for the foreseeable future as more than 70 million baby boomers enter their retirement years and their 60 million children enter the workforce.  This project is a reflection of that demand.

Pros:  The planned project is on-trend with changing lifestyle preferences and demographic shifts. In addition, its location certainly fits the sponsor’s strategy of investing in dense, urban, infill locations in fast growing cities of the sunbelt.

Cons:  This is the sponsor’s first ground up, for sale development.  While they are an experienced developer of “for rent” housing, the demand drivers, finishes, and complexity of a for sale product are completely different.  In addition, real estate is a local business and the sponsor’s broad focus on the “sunbelt” may hint that they lack the necessary local expertise in any one market.  

Lenders and Sources of Equity

Given their size and geographic footprint, it is normal that the sponsor would work with many different lenders.  This sponsor is no different.

From a debt standpoint, the sponsor works with a national lender out of their southeastern headquarters.

From an equity standpoint, the sponsor sources equity capital from wealthy, european based institutional investors, one of whom maintains an ownership stake and has final say in the deployment of capital.  Through this relationship, the sponsor has access to high quality tier 1 capital that is used to finance many of their projects.

Pros:  The sponsors have strong equity relationships to institutional capital, which could be accessed in the event of cost overruns or additional equity injections.

Cons:  Those same financiers are based in Europe, which has different financial standards and laws.  Transferring large amounts of capital across borders adds a layer of operational and legal complexity to the transaction.

Borrower Structure

The borrowing entity is a single purpose entity formed specifically for the purpose of constructing the proposed project.  Call them Borrowing Entity, LLC.

A separate entity, let’s call it Condo Project, LLC, will serve as the General Partner in the transaction and it is a wholly owned subsidiary of the Sponsor, Inc.  At the very top, Sponsor, Inc. is owned by the transaction principals and their European partners.  This structure is summarized in the diagram below:

Pros:  This structure is common and normal for a transaction of this size and complexity.  At the highest level, the transaction principals have an ownership stake in the sponsor, which gives them a vested financial interest in the transaction.

Cons:  While normal, this complicated legal structure provides several layers of insulation from liability in the event of a legal incident, bankruptcy, or foreclosure.  From a lender perspective, it could be very difficult to hold the transaction principals financially responsible because they are insulated from liability through all of the legal entities involved.

Borrower/Sponsor Analysis Summary & Recap

So, to recap this post, let’s look at the key questions from the beginning and see how the borrower/sponsor stacks up:

• History & Experience:  Does the borrower and/or sponsor have a demonstrable history of success with the type of project that they are requesting a loan for?  Can they demonstrate this with successfully completed projects or projects under construction?

Yes, the borrower has an extensive track record of successfully developing multifamily projects.  BUT, this is their first foray into a for sale product.

Conclusion:  POSITIVE

• Principals and Qualifications:  Do the transaction sponsor principals have the qualifications needed to execute the proposed project?

Yes.  The transaction principals have a significant amount of multifamily development experience and qualifications.  In addition, through several layers of entities, they have a vested financial interest in its success.

Conclusion:  POSITIVE

• Projects Under Development:  What projects does the sponsor currently have under development?  Are they similar to the proposed project?  Will they distract the borrower from completing the proposed project?

The borrower has four other projects under development at the time of the request.  Any one of these could be a potential operational or financial distraction.

Conclusion:  NEGATIVE

• Financial Strategy & Investment Approach:  What is the strategy and approach that the sponsor uses to construct and operate their commercial real estate assets?

The financial strategy includes a senior loan not to exceed 80% Loan to Value and 17.5% equity.  BUT, it also includes a mezzanine loan to finance some of the initial startup costs.

Conclusion:  NEGATIVE

• Business Plan & Geographic Footprint:  What is the business plan for the proposed project?  Where is it located and is it consistent with the sponsor’s geographic footprint?

The sponsor is targeting urban/infill locations in sunbelt growth markets.  Their business plan is on trend with changing demographics and lifestyle preferences.

Conclusion:  POSITIVE 

• Lenders and Sources of Equity:  What other lenders does the borrower/sponsor work with?  Where are they getting the needed equity for the proposed transaction?

The sponsor has access to institutional capital, which could be important in the event of cost overruns or unexpected events.  But, much of the capital comes from Europe, which can be difficult and or complicated to access.

Conclusion:  NEUTRAL

• Borrower Structure:  What is the legal structure of the borrower?  If it is a Limited Liability Corporation, who are the major shareholders and what is their relationship to the sponsor?

The legal borrower is a single asset entity, which is to be expected.  Its ownership is complex and involves several layers of entities between the parent company and the actual borrower.  While this is relatively normal, it could create significant complexity in the event of bankruptcy or foreclosure.

Conclusion:  NEUTRAL

All things considered, the sponsor is strong and experienced.  Despite the negatives, they are deemed to be acceptable.