This is the sixth and final post in our ongoing real estate private equity case study on how a construction loan is underwritten by potential lenders. This installment will provide a deal summary and a wrap up that includes a cautionary tale about construction lending. To read the previous posts in the series, click on the links below:
Post #1: Introduction & Setup
Post #2: Borrower Analysis
Post #3: Guarantor Analysis
Post #4: Repayment Analysis
Post #5: Collateral Analysis
The intent of this article is to provide a high level review of the proposed construction loan and a postscript about what happened after the request was submitted for approval.
By the end of this post, readers will have a complete understanding of how a construction loan is underwritten and it will be supplemented by an anecdote about what actually happened with the case study deal.
Let’s start with the review.
Deal Review and Summary
Remember, a lender’s primary concern in any loan is how they will be repaid. To that end, the evaluation of a construction loan focuses on four elements of the deal: the borrower, the guarantor(s), repayment, and collateral/market analysis. Below is a review of each of these elements in the case study deal:
The borrower is a single purpose entity formed specifically for this deal. Below is a summary of how they stack up against the lender’s borrower evaluation framework:
- History & Experience: The borrower has an extensive track record of successfully developing multifamily rental and condo conversion projects. But, this is their first foray into a for sale product.
- Principals and Qualifications: 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.
- Projects Under Development: 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.
- Financial Strategy & Investment Approach: 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.
- Business Plan & 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.
- Lenders and Sources of Equity: The sponsor has access to institutional capital, which could be important in the event of cost overruns or unexpected delays. But, much of the capital comes from Europe, which can be difficult and or complicated to access.
- Borrower Structure: 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 legal borrower. While this is relatively normal, it could create significant complexity in the event of bankruptcy or foreclosure.
Bottom line: the borrower/sponsor is strong and experienced. Despite the negatives, they are deemed to be acceptable and add strength to the deal.
The guarantor is a US subsidiary of a major international private equity firm. Below is a summary of how they stack up against the lender’s guarantor evaluation framework:
- Guarantor: The guarantee is at the corporate level, which provides access to a larger pool of resources, this is considered to be POSITIVE.
- Guarantee Type: The guarantor is required to provide an unlimited guarantee, meaning that they are responsible for the entire loan balance for the duration of the loan. This is also a POSITIVE.
- Income: The guarantor’s income stream is almost solely reliant upon the sale of condominium units. In addition, the small amount of net income relative to the loan amount is considered a NEGATIVE.
- Balance Sheet: The guarantor has $23MM in potentially realizable contingent liabilities versus $9MM in liquidity. This is NEGATIVE.
- Personal Credit: The guarantor is a corporate entity. As such, it is not necessary to pull individual credit. This is NEUTRAL.
The guarantee comes from a corporate entity with a strong reputation for quality developments and on time execution. However, their financial resources are not adequate to repay the loan in full if they were required to do so. In addition, they have a significant amount of potentially realizable contingent liabilities relative to their cash on hand. When all factors are considered, the guarantor does not add significant support to the deal outside of their legal responsibility to repay the loan should they be asked to. This is a NEGATIVE.
Repayment Summary and Review
The proposed construction loan has three sources of repayment: (1) funds from unit sales; (2) income from rental; and (3) guarantor recourse. Details on each are summarized below:
- Primary Source of Repayment: The primary source of repayment is the sale of condominium units.
At the time of the loan application, the developer has presold 293 of the 300 units in the project. The income from presales alone is sufficient to cover the requested debt at 1.05x. Once the remaining 7 units are sold, this is estimated to increase to 1.13x. This is a major POSITIVE.
However, to reserve their unit, potential buyers were only required to make a 5% deposit so there is some question as to how binding the “pre-sales” actually are. The 5% deposit is enough to be material, but not so much as to make a buyer think twice before walking away from a deal. Pre-sale deposits of 10% or higher would be more preferable. This is a NEGATIVE.
The benefit of the pre-sold units outweighs the negative from the smaller than preferred deposits. Overall the primary source of repayment is considered to be POSITIVE.
- Secondary Source of Repayment: The secondary source of repayment is the rental of unsold units.
Should some of the pre-sold units not end up closing, analysis was performed to see if it is possible to rent the units for enough to make the required loan payments. Based on the analysis, it is estimated that ~10% of the pre-sold units could fall out and market rents would be enough to cover the remaining loan balance. This is a POSITIVE.
However, any fallout greater than 10% would require rental rates that are at or higher than market averages, which could jeopardize repayment via rental. This concern is particularly prevalent because the pre-sold units only required a 5% deposit. A sudden market downturn or unforeseen issue could make it easy for a high percentage of buyers to walk away from their contract. This is a NEGATIVE.
The market in which the project is located is hot. Demand for condominiums is high and inventory is low. The risk of pre-sale fallout is not deemed material enough to impact approval. Overall the secondary source of repayment is considered NEUTRAL.
- Tertiary Source of Repayment: The tertiary source of repayment is guarantor recourse.
The loan is guaranteed by the US subsidiary of a major private equity firm. They have $9MM in liquidity and $23MM in potentially contingent liabilities. If any one of their other projects goes south, it could quickly absorb the availability liquidity and jeopardize the guarantor’s ability to support the requested loan. This is certainly a NEGATIVE.
The repayment verdict? Pre-selling 293 of 300 units prior to starting construction is an impressive feat and a testament to the demand for the project. Given the current sales pace, the remaining 7 units will almost certainly be sold prior to the start of construction, providing 113% loan coverage. This is unusual for a residential development project and provides a high level of comfort that the loan can ultimately be repaid. Overall, this is a POSITIVE.
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. Below is a summary of how the collateral stacks up against the lender’s evaluation framework:
- 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, functional 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.
What Actually Happened With This Deal?
After a complete underwriting review, the loan request was approved at the local level, but had to go to the national level “credit committee” for final approval. After a spirited debate by local representatives and the chief credit officer of the lender, the loan was APPROVED.
Obviously, the borrower was happy with the news and the transaction was quickly closed. Construction began shortly thereafter and the project soon became the face of a broader downtown revitalization effort.
A Cautionary Tale
Finally, after 6 posts and more than 10,000 words on this topic, we get to the most important point of this lesson. Construction lending is difficult and unpredictable. Delays and unforeseen events almost always happen, especially in larger projects, which underscores the need to be diligent and thorough when underwriting a deal. Cutting corners is a recipe for disaster and this project very nearly turned into one.
Approximately 2 months into construction – the foundation had been poured and the building was passing its third level – a routine inspection revealed hairline cracks in the concrete and an immediate question was raised about the structural integrity of the design. Construction was immediately halted and structural engineers were called in to examine the issue. After a nearly two month delay, it was determined that the safest course of action was to pump a massive amount of concrete reinforcement into the building and to adjust the design of future floors, which slightly altered the original unit sizes. After nearly 80 trucks full of concrete were poured, the building resumed vertical construction and was topped out shortly thereafter.
But, as the building was nearing completion, the broader economy collapsed. Demand for new units evaporated almost overnight and many of the buyers of pre-sold units got cold feet and walked away. Remaining buyers filed a lawsuit against the developer alleging that the building was unfit for occupancy due to the structural issues and that the final units were materially different than the ones they placed a deposit on (due to the necessary design changes).
The lender’s decision to allow 5% deposits on pre-sold units came back to haunt them in a big way (normal requirement was 10%). With the combination of the economic collapse and construction issues, nearly 30% of the pre-sold units fell through and could not be re-sold given market conditions. Further, the delays and added cost of the additional concrete exhausted the budget’s interest reserve and caused the borrower to have to take on even more debt.
In the end, the buyers who stuck with the project closed on their units and the loan balance was reduced. The units that went unsold were rented and the income was enough to make the loan payments on the remaining loan amount. The borrower survived legal challenges and the project was ultimately successful. But, it wasn’t an easy road and there were many dark days where bankruptcy seemed imminent.
Ultimately, the experience of the sponsor, their access to additional capital, and the lender’s willingness to renegotiate key terms of the deal was what saved it.
The key point is this. While it may seem like overkill to study even the most minute points of a construction deal before approving a loan, there is a good reason to do so. Construction is risky, unpredictable, and things rarely go according to the original plan. Lenders must consider all scenarios and take the appropriate steps to protect their capital, which is why they do so much due diligence before approving a request.