Q. I am a successful single-family homebuilder and have an opportunity to acquire a parcel of land that can be approved for a 20,000-square-foot office/warehouse building that I would like to build, lease out and retain for long-term investment. What will I need to convince a lender that this project is a good investment and worthy of financing?
A. All lenders want to know what their source of repayment is as a primary consideration when underwriting a loan. The source of repayment when you construct a house is the sales proceeds or profit, which can be calculated simply as sales price less various costs, including land, construction, closing and marketing.
The likelihood of the contractor actually making a profit is the risk that the lender must underwrite in determining whether to approve — and how much to approve for — a residential construction loan. If the house is presold, with the buyer having a financing commitment, the lender will be more inclined to grant the loan, and at a higher cost leverage. The other major risk with a reasonably assured presale is that the estimated costs of construction can be achieved, thereby providing a source of repayment for the lender and potential profit for the contractor.
When constructing a rental property vs. a for sale property, the risk characteristics of construction and profitability are similar, but the risk level is greater because of the increased components of the investment. No longer is the source of loan repayment tied to a singular sales transaction, but in a rental situation it is reliant upon receiving adequate rental income for a sustained period from the property.
Instead of building, selling, paying off the construction loan and making a profit in the above for-sale scenario, a rental scenario requires a construction loan during the construction and lease-up period and an additional term loan called a permanent loan for an extended period once the property is leased up and achieving a stabilized occupancy level.
Construction and permanent loans can be provided by two different lenders or by one lender in the form of a construction/permanent loan. The lender offering the combination loan structure will have a conversion provision within the loan allowing the construction loan to convert to a permanent loan when certain loan covenants (i.e. stabilized occupancy) are achieved. Achievement and adherence to these loan covenants or underwriting requirements are what the lender must be convinced of in order to provide the construction/permanent loan.
Loan covenants can be very extensive and detailed, but for simplicity’s sake, the project you are considering must be able to provide enough rental income to pay all operating expenses, debt service (loan payments) and provide a cash flow return to you.
Unlike the for-sale property that returns your investment to you at each sale, a rental property will usually require your investment (equity) to stay in the property for the period of ownership commonly called the holding period. The lender will want to see that projected rental income is achievable within a reasonable lease-up period and sustainable for the holding period. This information is usually provided in the form of a market study that will include information on competing projects, their rental rate, historic occupancy and absorption.
Operating expenses must next be identified. Quotes can be secured for some operating expense items, but other operating expenses will have to be estimated. Speaking with owners or managers of like properties can assist you in securing supportable operating expense estimates. Using supportable income and operating expenses, a financial analysis must be prepared including a development pro forma and cash flow projection. The financial analysis will illustrate project performance applying the costs of development and construction, the timing of construction and lease-up to the net operating income from stabilized occupancy.
Preparation of this information will be the first step in evaluating potential financing alternatives and the success of the project.
Lenders evaluate a loan request from many aspects, including credit, experience and liquidity of the sponsors, in addition to the financial information described above. Developing a new product type will require the lender to get comfortable with your ability to do so, and assure the lender that there are adequate reserves available should the projected construction costs, timing and lease-up not be achieved as planned.
David B. Eaton, president of Eaton Partners, Manchester, manages the firm’s Commercial Mortgage Group. Questions can be submitted to him at Commercialnotes@eatonpartners.com.