Los Angeles Private Lender Expands into Distressed Residential Market
October 17thConstruction-to-perm debt funds the acquisition, construction, and post-construction periods of property development in a single financing facility. The product serves developers that plan to construct or significantly renovate real estate for a long-term hold, while merchant builders find it advantageous for the construction of pre-sold projects. Construction-to-perm loans eliminate take-out financing risk and interest rate volatility during the construction period. They also lock-in levered returns and reduce the costs and friction of obtaining separate construction and permanent debt facilities.
Construction-to-perm loans are typically offered by portfolio lenders, most notably life companies and pension funds (or pension fund advisors). These institutions possess “on-book” capital, and therefore can commit to long term investments. Lenders that depend on securitization for liquidity are not able to competitively offer this type of financing. HUD/FHA’s 221(d)(4) program is a unique source of construction-to-perm loans for multifamily and healthcare products.
Construction-to-perm loans are reserved for large, institutional quality projects. In particular, lenders look for well-positioned class “A” assets in major metropolitan markets. The qualifying sponsor must display deep expertise, a long track-record, and strong financial condition. The business plan should present a low risk lease-up/stabilization plan, like apartments or significant credit-tenant pre-leasing. If a life company or pension fund would not otherwise buy the project at stabilization, they are unlikely to fund it with construction-to-perm financing.
Rates are fixed for the entire term, including the construction period. Interest is only calculated on those proceeds advanced, not on the full notional loan commitment. The interest rate is a composite of a U.S. Treasury index and a market rate spread. A forward commitment premium (estimated based on the loan draw schedule) and a construction risk premium are factored into the spread. As such, the rate is typically higher than that of a perm loan on a stabilized asset ready for immediate permanent loan funding. However, the elimination of interest rate and take-out risk during the construction phase is a significant benefit.
The loan commitment is typically sized to the maximum stabilized permanent loan. Loan proceeds are drawn down as needed for construction, after the sponsor’s equity contribution. However, funding during construction may be limited below the total committed loan proceeds. This is done to ensure the sponsor’s equity contribution is meaningful. Any unfunded balance remaining at the time of completion is released to the sponsor or borrower as a return of equity.
Construction-to-perm loans are almost exclusively non-recourse. However, the borrower must guaranty completion in addition to lender protection from fraudulent acts and environmental risks.
Footnote: Major pension funds will fund both debt and joint venture equity tranches approaching 100% of project capitalization, but only for the most desirable institutional projects. They thereby essentially “buy” the project from the start of construction, while paying the developer fees and a risk-adjusted promoted return. This is a relatively expensive method of capitalizing a construction project, which gives away much of the profits to the institutional partner and puts the developer in non-controlling role. Regardless, it simplifies the financing process, significantly reduces the developer’s risk, and equips them for relatively large construction projects.
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