I thought an article about commercial construction lending underwriting would be the best choice to start a category of “Spilled Milk” type of articles similarly to the way that the old RMA journal had articles about commercial loans gone bad.
The difference is that in this case, I am not going to tell the story about a particular loan that went bad, but instead I am going to list a series of underwriting guidelines. Hopefully these guidelines will give someone some idea as to what to look for if your boss wants you to underwrite a commercial construction loan, and you lack the experience. A lot of these guidelines have been gathered over the years, and with the benefit of having gone through the recent recession.
The first and most important factor that you must analyze is the sponsor. The following needs to be answered and documented:
- Does the sponsor have the experience and track record with the type of project being undertaken?
- Is the sponsor experience in the market where the project is located?
- Is the sponsor providing a full unlimited guaranty?
Once the preliminary questions about the sponsor are answered, you can move to a more in depth analysis of his financial condition. As a general rule, it is good form to request a “developer’s schedule” from all of your real estate investors. This schedule provides a listing of all of their ongoing projects, their location, the type, the stage of completion, the associated debt, income, expenses, NOI, ownership percentage, etc. From that schedule, their personal financial statement, and conversations you should be able to answer and document the following:
- The status of other projects.
- Anticipated cash flow based on the status of other projects as well as recurring cash flow.
- An overview of the contingent liabilities.
- Existing unsold inventory (inclusive of other projects as well as the one you are looking to finance).
- Absorption of the projects.
- Liquidity (very important to assess the liquidity as well as the possible claims on that liquidity by looking at the contingent liabilities) You really want to make sure that the sponsor can step in if the project slows down.
In addition to the sponsor, there is another party that the lender has to look at when dealing with commercial construction underwriting (the contractor). Although it is very possible that you will not get this information when you are writing up the memo because the contractor might not have been chosen yet, you can cover this easily by adding a couple of conditions to the loan agreement.
- The first condition should make sure that the lender has some control as to who the contractor is. You will require that the contractor provide some background to make sure that he is experienced, and you might even want to get financial statements from the contractor to make sure you are dealing with a stable third-party.
- The second condition requires bonding as you want to make sure that the project is completed and you don’t end up having to take over a half finished shell.
Once that is done, the following step should be to come up with a good loan structure that provides the financing that your borrower is looking for, but also safeguards the lender. Some points you need to make sure to cover are listed below:
- Not all of the construction projects are the same. For example, an apartment building in a place with demand has less inherent risk than a custom made single/limited purpose building.
- Your maturity/transition to permanent financing must make sense.
- There must be built in performance parameters (it is all about controls and requiring additional equity or paydowns if those parameters are not met).
- Do not forget to set appropriate interest reserves as well as contingencies in your sources & uses.
- The sources & uses must have clearly itemized line items.
- Developer’s fee should be reasonable and paid as project progressed or at the end. Remember that the lender gets paid first and the developer should get paid last.
- Equity must be in the project before the lender starts disbursing funds. Stay away from deferred equity.
- Remember that the level of commitment to a project is directly related to how much of their own actual money is in the project.
- A lot of times, the developer’s equity will be in the form of land. This is something to watch out for in an environment of rising land prices. As we have learned, that which goes up fast can also come down fast.
- The project has to make sense for its location and current market conditions.
- The analysis must include a realistic projected absorption, and this absorption must support the proposed terms of the loan. The appraisal is a great source for this information.
- In “for sale” projects, you want to limit sales to multiple purchasers and investors.
- Conservative underwriting dictates that you build in conditions limiting the number of “specs” (units without a contract), require presales, and that release prices are set so that the loan is fully repaid once 75% or 80% of the units are sold.
This is not a fully comprehensive look at construction financing, but should give you an idea of what to look for, and what to ask for in order to make sure that risks are mitigated. Hopefully after reading this, you will be able to say “I have not underwritten one, but I think we need to make sure that we cover these bases”. Or if you are already experienced in this area, I was at least useful in reminding you of some points.
Construction Lending - Credit AnalysisUnderwriting primer
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