Commercial and multifamily construction lending activity has significantly increased in volume since its nadir concurrent with the economic downturn commonly referred to as the Great Recession. The commercial real estate industry has recovered, and the fundamental demand drivers for new construction are strong. However construction lending by commercial banks has become more challenging as regulatory changes now require banks to hold more capital against many types of construction loans. New sources of capital are developing, and a new paradigm for construction lending is emerging. Non-traditional construction lenders such as life insurance companies, specialty finance companies and REIT’s, are funding new commercial and multifamily construction projects. Many of these lenders are using third party construction loan administrators to manage the risk inherent with construction lending instead of building the requisite resources and infrastructure in-house.
Construction lending has historically been the province of commercial banks. Construction loans are the cornerstone of bank real estate lending activities. Community and regional banks extend construction loans to local developers; national banks lend on larger projects, and the largest developments are typically financed through bank syndicates. Banks provide the short-term, floating rate financing and associated construction loan administration through completion of the project, lease-up and stabilization. On project completion and stabilization, portfolio lenders or issuers of commercial mortgage-backed securities provide the permanent fixed-rate financing.
Total commercial construction activity (excluding public works and infrastructure) has recovered from the declines associated with the economic recession starting in 2007. Total commercial construction start activity peaked in 2007 at $300 billion in volume. By 2011, construction start volume had declined by 38 percent from its peak to $186 billion. Volume is projected to approach $280 billion in 2015 (source: McGraw Hill Construction Research and Analytics).
Commercial construction is fundamentally a local activity. The economic drivers of commercial and multifamily construction vary by property type and include occupancy, rental income growth, retail sales, housing starts, household formation and other factors. Generally, these factors have been trending positively in many local markets and are generating new construction starts. The American Institute of Architects projects the average of all non-residential construction activity to increase by 7.7 percent in 2015 and 8.2 percent during 2016. Of the total commercial construction, approximately $60-70 billion annually may be funded through non-bank lenders.
The implementation of Basel III capital rules has had a negative impact on the availability and cost of construction lending by commercial banks. Specifically the High Volatility Commercial Real Estate (HVCRE) regulations have increased the regulatory capital required for banks to hold against real estate construction lending activity, and made certain higher leverage or speculative construction lending activities prohibitively expensive. These regulations have increased the equity required from developers and limited the contribution of appreciated land to fulfill this equity requirement. This disruption in commercial bank construction lending activity is creating opportunities for non-regulated lenders to increase their market share in the sector. These lenders are seeking the higher yields associated with construction lending, as well as the opportunity to place permanent loans on the completed projects.
During the past economic downturn, portfolio lenders were opportunistic in providing permanent loans on high quality assets. Currently insurance companies have been aggressive in bidding for well-located, institutional grade properties with strong tenants and sponsors. Portfolio lenders and specialty finance companies have been very competitive on permanent loans secured by properties net leased to high quality tenants including the federal government, healthcare and academic institutions. Loans on institutional-quality multifamily properties and properties leased to investment grade rated tenants are also in high demand. Specialty finance companies have also emerged to provide financing for smaller commercial construction projects.
To secure these permanent loans, life insurance companies and specialty finance companies are offering combined construction / permanent loans. Developers find this type of construction / permanent loan an attractive alternative to finance their properties. Borrowers can take advantage of today’s low interest rate environment by locking in attractive financing and realizing the efficiencies of a single negotiation and loan closing. They also limit their risks associated with having to secure permanent financing in an uncertain future market environment. Mortgage bankers are finding opportunities to represent borrowers and to place these types of construction / permanent loans with their portfolio lending relationships. In many cases, these non-bank lenders lack the internal expertise and resources and use third party construction loan administrators to support this activity and to manage the financial risk associated with the construction financing.
Third party construction loan administrators provide an efficient and effective means of risk management and project financial oversight for lenders who do not have the in-house resources and capabilities to offer construction loans. This construct provides the lender with the expertise and resources to manage construction lending risks related to contractual, budget, design and scheduling matters. On behalf of the lender, the construction loan administrator is responsible for monitoring the project budget including all designated sources and uses. Additional responsibilities include managing any reserves that are provided to cover shortfalls, coordinating the on-going due diligence services (including inspections and title updates), reviewing disbursement documentation, and providing detailed client reporting on the status of the project and fundings. The construction loan administrator provides the financial oversight and risk management, and coordinates with the project-inspecting engineer and the design professionals who conduct the physical construction oversight.
Third-party construction loan administrators are typically engaged prior to closing, at which time they complete a document and budget review, participate in closing activities and attend the initial planning meeting. Post-closing services include construction and budget monitoring and rebalancing, disbursement administration, title management, loan servicing, and reporting.
As part of the pre-closing services, the construction loan administrator will review the lender term sheet, initial loan documents, title administration process, line item budget of total costs and other supporting materials, and follow up with the inspecting engineer with respect to the plans and specifications, construction contract and supporting schedules. The construction loan administrator will typically participate in a preliminary meeting among the development team, which may include the general contractor, project architect, borrower representative, inspecting engineer and business representatives of the lender. The primary goals of this initial planning meeting are to establish and review disbursement procedures, draw backup, and communication contacts for the project. The loan administrator will also typically participate in the loan closing process.
After the loan closes and construction commences, the loan administrator’s activities intensify. In monitoring the project budget, the loan administrator provides a summary of budget revisions and reallocations, or summary notation of any budget discrepancies or out-of-balance situations, as well as a change order summary addressing related questions or concerns, such as budget adequacy, timing or other issues. This budget analysis process refers to an evaluation of the adequacy of the complete hard and soft cost budget.
Financial controls are an important component of the construction loan administrator’s responsibilities. The loan administrator reports on funding status, including allocation of approved, eligible costs for equity and loan proceeds, and other sources of funds (e.g., grants, reserves, tenant reimbursables), highlighting the current disbursement request amount, previous amounts disbursed and amount remaining to be funded. The loan administrator coordinates with the inspecting engineer with respect to the hard cost draw request with physical on-site validation of the work in place to document the loan draw process and construction progress towards completion.
On a regular basis during construction, the loan administrator makes a recommendation of the amount of funds eligible for disbursement and related items requiring follow up. A disbursement summary is provided to the lender, which may include a list of exceptions to pre-established guidelines such as funding restrictions or document requirements. Typically, this review of disbursement requests and funding is performed once a month.
Loan administrators with banking affiliates can provide additional financial controls through treasury and cash management services specific to the project needs. During construction, the loan administrator can issue direct or dual-payment checks to the general contractor and approved vendors from escrowed loan or equity funds. For condominium projects, residential sales deposits can be tracked unit-by-unit with detailed accounting of earnest money, upgrades, customizations and interest. Commercial lockbox accounts can be established with effective cash distribution waterfall accounting.
Maintaining the title administration process is an important part of the loan administrator’s on-going responsibilities. This activity includes coordinating the request for title searches and bring-downs prior to each funding, and obtaining the written endorsement to evidence the updated title coverage. As part of this process, the loan administrator manages interim exception documents and identifies options for resolving open issues.
One of the construction loan administrator’s most important functions is to review project performance by monitoring project leasing or sales activity. Residential project information includes review of purchase agreements, adherence to prequalified sales criteria, requests for variances or concessions, and unit closing and release detail. Commercial leasing is monitored for adherence to predetermined criteria, tenant improvement thresholds, and lender acceptance.
Some construction loan administrators have experience in providing special credit management and resolution services in the event of default. These services include assisting the lender in developing and implementing an asset management plan to address the workout, restructuring and disposition of under-performing and defaulted construction loans, with the specific focus on resolving the unique issues inherent in distressed construction projects. The asset management plan is a detailed assessment of the project construction status, market, valuation and financial analysis of alternative resolution strategies. A critical part of this analysis is whether the borrower is the problem or can be part of the solution.
Qualified third-party construction loan administrators can provide an invaluable resource to lenders who do not have the internal expertise and capabilities to manage construction loans. The loan administrator’s experience related to financial risk management is a critical, value-added expertise. Construction loans are inherently risky, and a professional construction loan administrator can provide a wealth of experience to manage and mitigate these risks. The use of a third-party service provider also is economically efficient, allowing the lender to have the resources available only when needed and paying variable expenses as their construction lending volume increases and decreases over time. This business model is expected to gain further market acceptance as the commercial construction lending business revives.