Sunday, November 3, 2013

Navigating Commercial Construction Financing



Today, the development and construction of commercial facilities entails a wider range of financial options than anytime in the past quarter century.

Thanks in large part to continued low interest rates and significant liquidity in lending institutions, financing of well-considered speculative projects is available. Having learned the lessons of the tumultuous 1980s, however, such financing is generally considered conservative and follows the precepts of responsible investment. These precepts include significant borrower equity and responsible management available to sponsor the debt.

From a financing perspective, development of commercial facilities falls into two general categories: owner occupied facilities, and investment facilities. The latter can be speculative for lease, include some pre-leasing, or it can be a wholly-occupied build-to-suit project.

Financing of owner occupied facilities typically involves commercial banks and similar short term lenders and entails rather standard pro forma proposals that enumerate the market scope, past performance, revenues, capital costs, and potential for future expansion. Since the owner occupant has business cash flow it is easy to determine his ability to repay. Responsibly generated, those numbers will reveal whether and how much an enterprise can afford to build.
In an effort to nurture small businesses, the U.S. Small Business Administration offers a highly advantageous SBA-504 loan program aimed at small business owners who want to develop or acquire their own facilities.

SBA-504 loans are not as well known as conventional financing, although the benefits they offer to the business owner are enormous and significant. SBA-504s require a skill set most commercial banks offer but usually reserve for portfolio transactions that are of greater benefit to them as a lending institution. Mercantile Commercial Capital, which focuses on SBA-504 loans almost exclusively, rose quickly to prominence based on superior skills, dedication and services only enhanced by the severe dearth of SBA-504 specialized lenders in Florida.

SBA-504s offer business owners below market interest rates with a capital investment of as low as 10 percent of project costs. That advantage, of course, frees valuable capital for business operations and substantially reduces the risk to the business owner. Typical commercial loans require at least 20 percent capitalization -- the amount the business owner contributes. In addition, terms range from 20 to 25 years with the SBA rate fixed for the life of the term.

SBA-504s can be used to finance development and construction of new facilities or acquisition of existing facilities in the $500,000 to $6 million range.

Development of for-lease facilities entails a larger set of requirements and developer commitments. Measuring the feasibility of an owner-occupied facility is much more reliable than assessing the market, distributing risk and determining feasibility for a "for-lease" facility.

"Capital", in this case, is the money that owners or developers contribute toward land acquisition, planning, development, construction and marketing a project. "Financing" is the money that the developers borrow to leverage that capital.

Institutional lenders, such as insurance companies, do not typically finance construction unless they are equity participants. Construction financing is typically the purview of savings and loans, commercial banks or similar financial intermediaries.

Construction loans typically cover costs during the time it takes to build the project and get it leased up. After that, permanent lenders -- including insurance companies -- should come into play for those projects large enough to get on their radar screen. The name of the game is interest rates. The object is to lock in lowest interest rate. In low rate markets the developer will want to complete construction and establish cash flow as quickly as possible to move to the permanent market. In high interest rate markets, the developer may want the construction lender to provide mini-perm financing, typically one to three years until a lower rate environment presents itself.

In many instances, a strong developer can convince an insurance company to provide a forward commitment. Construction is financed by a typical commercial lender, and the forward commitment will "take out" the bank once construction is completed and leasing occupancy has reached a certain level. Management of this process requires an understanding of the likely movement in interest rates.

Large-scale, phased projects offer the opportunity to secure construction financing from institutional lenders based on the phased project performance. If leasing activities in the first two phases clearly demonstrate demand by the time development of a third phase starts, an insurance company may step in and fund all three phases, putting third phase construction money in escrow. The insurance lender relies on the fact that leasing revenues in the first two phases are adequate to serve the debt. The obvious advantage of this strategy is to lock in today's interest rates.

Pension funds use generally the same standards, although pension fund managers will occasionally take on a little more risk. However, one must remember insurance companies and pension funds want stable income. Permanent lenders underwrite underlying leases and the strength of the real estate transaction. They have cash flow needs and the stability of their income is paramount to meeting their obligations.

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