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Leveraged Breakdowns

Underwriting a Construction Loan – Collateral Analysis

This is the fifth post in our ongoing real estate private equity case study on how a construction loan is underwritten by potential lenders.  This installment will focus on collateral analysis.  To read the previous posts in the series, click on the links below: 

Post #1Introduction & Setup

Post #2Borrower Analysis

Post #3Guarantor Analysis

Post #4Repayment Analysis

The intent of this article is to describe how a construction lender evaluates loan collateral.  Specifically, the article will review:

  • What collateral analysis is and why it is important
  • Why the construction budget and interest reserve matters 
  • The importance of general contractor analysis 

By the end of this post, readers will have a greater understanding of how collateral analysis is conducted and should be able to incorporate this knowledge into their interactions with real estate lenders.  In addition, this information could come in handy as part of a REPE Technical Interview.

Let’s start with an overview of collateral analysis. To jump directly to the summary section, click here.

What is Collateral Analysis?

In our post on repayment analysis, we noted that the secondary source of repayment in most commercial real estate construction loans is the sale or rental of the property.  To this end, the primary goal of collateral analysis is to determine whether or not the pledged collateral can be sold or rented for an amount that is sufficient to repay the loan.  In other words, the lender performs collateral analysis because they don’t want to be stuck with a piece of collateral that nobody wants.  If this were to happen, they may have to sell it at a big discount, which could result in a loss. 

In their analysis, the lender will review the following aspects of the pledged collateral:

  • Project overview 
  • Unit mix 
  • Unit size, layout, and finishes 
  • The construction budget, including the estimate for interest reserves 
  • The construction timeline and whether or not it is realistic 
  • The contractor’s qualifications and experience
  • The market appetite for the finished product
  • Covenants and conditions 

With this in mind, let’s see how our case study project stacks up.

What is the Collateral?

The collateral for the loan is a First Real Estate Mortgage (FREM) on the proposed mixed use property to be constructed.  In addition, the lender will receive an assignment of all rents, leases, and contracts.  There are two very important points about this collateral description.

First, a “first” mortgage means that the lender has first position lien on all of the units and will not “release” it until an individual unit has been sold and the loan has been paid down by the required “release price.”  In other words, the “first” position means that the lender will be the first one to be repaid from unit sales.  Investors and other stakeholders will not be repaid until the lender’s loan is satisfied in full.  This is why they are referred to as the “senior” lender.

Second, the assignment of rents, leases, and contracts is important because it means that the lender will have the ability to step in and control the project should something go astray.  With an assignment of rents and leases, it means that they are entitled to receive payments from tenants and/or contracts until their loan is repaid.  Specifically, the assignment of pre-sale contracts in this deal means that the lender can step in and manage the sales process until their loan has been repaid.

With this collateral in mind, let’s take a closer look at the project itself.

About The Project

The proposed project consists of 300 residential condominium units along with a ground floor retail space that has already been leased to a major grocer.

About the Units

Within the 300 units, there are 12 different floor plans, a penthouse, and six unique poolside villas.  The units range in size from 650 SF to 4,500 SF and unit prices range from $350 PSF to $500 PSF.  All units will have high end finishes including energy efficient appliances, hardwood flooring, solid surface countertops, and high speed internet ports.

In addition, all condominium unit owners have access to an impressive set of amenities including a health club, an indoor/outdoor community space, a resort style pool deck with a 120 foot heated pool, jacuzzi, and private poolside cabanas.  In addition, the project will feature an elegant porte-cochere, dedicated parking, and 24 hour security and concierge services.

Project Location

The project is located in a fast growing neighborhood of a major city in the southeast.  In recent years, the surrounding neighborhood has exploded with luxury condominium projects and the influx of new residents has also led to the opening of high end retailers, boutique shops, and chef-driven restaurants.  

The specific parcel upon which the proposed project will be constructed sits adjacent to the crown jewel park in town and unit owners on high levels will be rewarded with fantastic views of the city skyline and the park.

To summarize, this is a large project in a very desirable neighborhood with an A+ location.  Unit finishes and amenities will be best in class.  As a result, this project is seen as very POSITIVE.

The Construction Budget 

As part of the approval process, the borrower submitted a detailed line item budget to the lender.  It is summarized in the table below:

 CostEquityIncentivesLoan Proceeds
Land, Land Closing & Carry Costs$8,000,000$6,000,000$0$2,000,000
Hard Costs$115,000,000$4,500,000$10,000,000$100,500,000
Hard Cost Contingency$5,500,000$0$0$5,500,000
Soft Costs$10,000,000$0$0$10,000,000
Loan Costs$2,000,000$0$0$2,000,000
Interest Reserve$10,000,000$0$0$10,000,000
Developer Fees$5,000,000$5,000,000 $0

There are three important points about this construction budget:

  1. The total cost is estimated to be $155.5MM, of which $130MM will be advanced in loan proceeds.  This means that the loan to cost ratio is 83%.
  2. The budget includes a line item for contingency of $5.5MM.  These funds are “just in case” the project goes over budget and, hopefully, will not actually be spent.
  3. Through a combination of upfront cash payments (for the land), deferred equity (the developer fee) and city incentives, the borrower is investing $25.5MM of their own money into this deal, which is a sign of their commitment to it.

An accurate and reasonable construction budget is absolutely critical to the success of the project.  Any cost overruns that exhaust the planned contingencies can represent a significant risk for both the lender and the borrower.  For this reason, the lender has commissioned an independent review of the budget by an expert to ensure it is sufficient for the planned project.

At this point, the budget appears to be reasonable, but this will be confirmed by the independent review.  For the moment, the budget is considered NEUTRAL.  If it is approved by the consultant, this will change to a positive.

About The General Contractor

This is a big, expensive, high profile, and complicated project.  As such, it needs a general contractor who has the experience and qualifications necessary to execute it.

For this project, the borrower has selected a regional general contractor with a national reputation for quality work.  They have been in business for 60 years, have offices all over the southeast, and specialize in high rise condominium construction.  As part of their bid, they will provide a full suite of construction and construction management services.

Perhaps the most important qualification for this general contractor is that they have already successfully completed a similar project for the same developer that is located directly across the street from the proposed building.

From the lender’s standpoint, there are three very important points about the selection of this contractor.  First, they are requiring a fixed price contract, which will place the burden of cost overruns on the contractor.  Second,  as a condition of approval, they are requiring a detailed review of the contractor’s finances.  Anything that is deemed unacceptable could derail the deal.  Finally, the contractor will be required to submit an unconditional payment and performance bond, which provides additional protections for the lender.

Until the full review of the contractor has been completed and their performance bond has been submitted, this aspect of the collateral is NEUTRAL.

The Construction Timeline

Again, this is a big, complex project so it will take a long time to complete.  In conjunction with the contractor, the borrower has indicated that the total construction time will be 26 – 30 months.  This is important for 2 reasons.

First, the term of the loan is 36 months.  So, there is a relatively narrow margin for delays…and there are always delays.  If the project were not to be completed by the time the loan matures, an extension would have to be negotiated and it could be very expensive for the borrower.

Second, the “interest reserve” line item in the budget above – which is used to make the loan payments during construction – is calculated based on the amount of time it takes to complete the project.  Another consequence of extended delays is the increased risk that the interest reserve will be exhausted.

Given the small difference between the planned construction period and the term of the loan, this timeline is considered to be NEGATIVE.  If the term is a negative, it can be tempting to ask, “why not just make it longer?”  This is because the term is driven by a lender’s “credit policy” for each type of loan and there is relatively little room for negotiation to change it.  Doing so would require an “exception” to the lender’s policy which can prolong the approval process because it requires additional sign offs and invites closer scrutiny of the deal.

Market Analysis 

As a precursor to the market analysis, it is important to note that the project has pre-sold 293 of its 300 units.  In this case, a “pre-sale is defined as a unit for which a potential buyer has placed a 5% deposit.  For example, a $500,000 unit would require a $25,000 deposit” to qualify as pre-sold.  This fact alone indicates strong market acceptance of the project.  However, it is not guaranteed that all of these pre-sales will close so it is still important to analyze demand for the product in the market.

Micro Market

As previously stated, the project is located in the most desirable neighborhood of a fast growing city in the southeast.  The specific parcel is located across the street from a popular park within the downtown corridor and the surrounding neighborhood has been a target of significant redevelopment in recent years.  

The neighborhood is characterized by cobblestone streets, renovated single family homes, street level retail stores and restaurants, and a number of mid/high-rise condominium projects that are either under construction or in the planning stages.  Within a 5 mile radius of the project, the population has increased at a 4% annual clip, which outpaces just about every other neighborhood in the metro area.

Over the last 5 years, the condominium market in this neighborhood has experienced major growth due to its desirability and proximity to the central business district, interstate, airport, and area attractions.  Two years before the subject project was proposed, there were just 300 condominium units in the neighborhood.  At present, there are 2,570 units that are either recently completed, under construction, or in the planning stages.  They are summarized in the table below:

Project# of UnitsAvg. PriceUnits ClosedUnits Under ContractRemaining UnitsCurrent Status
Project #1375$475,000030075Under Construction
Project #2360$176,00036000Complete
Project #3300$200,00030000Complete
Project #4240$300,00024000Complete
Project #5175$600,000015025Under Construction
Project #650$435,0000500Under Construction
Project #725$350,0000250Under Construction
Project #820$460,0002000Under Construction
Project #9125$175,00001250Under Construction
Project #10300$360,00003000Under Construction
Project #11300$450,0000150150In Planning

From the table, it can be seen that, of the 2,570 units, 920 have been sold and closed, 1,393 are under contract, and there are just 257 units remaining.  These numbers indicate strong market demand for the project, which is a major positive.  However, these numbers must be taken with a grain of salt because the vast majority are under contract, not actually sold.  These sales could collapse and flood the market with unsold units, which would be a negative for the proposed project.

But, again, 293 of the units for this project are already pre-sold before even one shovel worth of dirt has been turned.  There is a high degree of confidence that the remaining units will be sold prior to completion, which is very positive for the project.  As a result, market demand is considered to be POSITIVE.

Covenants and Conditions 

Loan “covenants” are promises that the borrower makes to the lender and loan “conditions” are items that must occur prior to final approval.  To protect themselves in this transaction, the lender is requiring several loan covenants and conditions related to the collateral.  Among them:

  • Budget/plan analysis to be performed by engineer or third party consultant 
  • Lender to require monthly inspections during construction 
  • Lender to require satisfactory environmental report 
  • Lender to require satisfactory appraisal prior to closing 
  • Lender to require proof of adequate zoning, survey, soils test, and utility availability prior to closing 
  • Lender to require assignment of plans, specs, permits, and contracts prior to closing 
  • Approval subject to bonding and approved analysis of the general contractor 
  • Borrower to provide evidence of presale contracts 

Why would the lender go so far as to add these covenants and conditions regarding the collateral?  Simple, to protect themselves.  For example, the borrower is claiming that they have 293 pre-sale contracts so the lender is requiring them to provide evidence of this to ensure the contracts are satisfactory and binding.  If they are not, it could dramatically change the risk profile of the transaction.

These covenants are neither positive or negative, but they are in place to put some structure around the transaction and to provide some protection to the lender in the event that the borrower has misrepresented some facet of the deal.

Summary & Review

Again, in a typical construction loan, the secondary source of repayment is the rental or sale of the constructed project.  To that end, the point of collateral analysis is to ensure that the lender would be able to do just this and obtain enough sale or rental income to repay their loan.  In short, they don’t want to be stuck with a piece of collateral that is unattractive in the market.  

In the proposed transaction, the collateral is a first position lien on a prime piece of real estate and all improvements thereto which include 300 residential condominium units and commercial rental space.  In addition, the lender will receive an assignment of all rents, leases, specifications, and contracts.  

When a lender performs collateral analysis, they look at the following aspects of the property:

  • Project overview 
  • Unit mix, size, layout, and finishes 
  • The construction budget, including the estimate for interest 
  • The construction timeline and whether or not it is realistic 
  • The contractor who is responsible for building the project
  • The market appetite for the finished product
  • Covenants and conditions 

Let’s see how our case study project stacks up against each one of these dimensions:

  • Project Overview:  The project includes 300 residential condominium units across 12 floor plans, a penthouse, and six poolside villas.  It has a prime location in the most desirable neighborhood of a fast growing city in the southeast.  This is a POSITIVE
  • Unit Mix, Size, Layout & Finishes:  Units will range in size from 650SF to 4,500SF, which is within the boundaries of the local market.  They will have open concept, function layouts and high end finishes including hardwood floors, solid surface countertops, and high speed internet access.  In addition, the property will feature an impressive amenities deck that includes a pool, jacuzzi, private cabanas, and indoor/outdoor community space.  These are best in class for the market, which is a POSITIVE.
  • Construction Budget:  The borrower has provided a budget that was created in conjunction with their general contractor.  It includes $155.5MM in total costs which will be paid for with $25.5MM in equity/incentives and $130MM in loan funds.  As part of the loan approval conditions, the budget and plans will be reviewed by a third party engineer/consultant.  Until they are deemed acceptable, this is NEUTRAL.
  • Construction Timeline:  The planned construction period is 26-30 months.  The requested loan term is 36 months.  This leaves little room for delays so it is considered a NEGATIVE.
  • Contractor:  The contractor is a regional firm who has 60 years of experience, including previous projects with the developer.  Loan approval is subject to a full review of the contractor and their finances.  In addition, the contract must provide a full performance bond.  Until these items are completed, the contractor is considered NEUTRAL.
  • Market Appetite:  There is no better evidence of the market’s demand for this product than the very impressive presales on the project.  This is a POSITIVE.
  • Covenants and Conditions:  As part of the approval, the lender is making approval subject to a set of covenants and conditions that are designed to protect their interest in the deal.  This is NEUTRAL, but if the borrower is unable to perform, it could be negative.

Given the strong pre-sales, growth of the local market, and proximity to major points of interest in the city, the collateral is considered to be strong.  Overall, this is a POSITIVE for the deal.

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