Lender Underwriting Model For Construction Loan on Multifamily?
Does anyone who lends on multifamily development projects steer me in a direction on how you underwrite a project to determine the LTC (how much you can lend)? Between what the borrower bought the land for, TDC, and stabilized value etc. what factors are you looking at?
Is there a model you can share with all of the inputs?
For my firm it's almost always based on/limited by cash flow, i.e. debt yield or DSCR. Typically the borrower has a specific request for what LTC % they want, based on their capital needs and return requirements. We compare the NOI vs. that loan amount, if it results in an acceptable debt yield or DSCR, then we're good to go. If the debt yield is too low, than we back into a (lower) loan amount that generates the DY/DSCR we want.
The main factors that differentiate lenders in terms of 'sizing' (i.e. how much they can lend) is, generally, (i) how do they underwrite NOI, and (ii) what debt metrics do they 'need.'
For example (fake numbers):
In practice it's not as black and white. The lender may 'stretch' (i.e. we'll lend the full 70% LTC even if the DY is below what we typically look for) for a variety of reasons - they have a strong relationship/track record with the Borrower, like the deal or market, etc. Conversely, even if the DY is strong, they might lend a lower LTC due to other risks (market risk, profile of the borrower and experience, etc.).
Also, while LTC/LTV is normally secondary to DY/DSCR (at least for cash-flow focused lenders), it still can end up being a limiting factor (i.e. we won't above 75% LTC regardless of what the DY is, because of our own internal credit policy). This is also where recourse/non-recourse comes into play. If the Borrower is willing to sign a repayment guaranty (aka provide recourse), the lender will usually be OK with higher leverage and lower DY/DSCR.
Note - I'm talking from the perspective of a bank doing senior balance sheet loans. Other construction lenders (i.e. debt funds) usually can get more aggressive on leverage and DY in exchange for higher pricing (interest rate), and care less about recourse.
what an amazing response! Posts and answers like this are the reason why I keep coming back to WSO...
Seconding this, very helpful and clear
Very interesting that debt yield is your most important metric, which definitely makes sense.
Quick q - since DY accounts for NOI, what happens or what protections do you have if a borrower defaults on the building mid construction. In this case there’s no NOI, so you’re just banging on the value of the land and improvements? How do you go about this?
Technically we focus more on DSCR than DY (though we measure both), but I use DY in these examples because it's simpler and more apples-to-apples. But yeah both are NOI/cash-flow focused.
To your question, we structure the loan with provisions that (a) heavily incentivizes the borrower to complete construction and (b) gives us legal protection if something goes wrong. Dealing with / owning with a half-built, or even fully-built, project is a bank's worst nightmare, so we do everything we can to avoid that. In other words, even if they hit a road bump, construction is stalled, they're technically 'in default,' etc., we'd much rather work through the pain with the borrower and get the project complete (using the below protections/incentives as leverage), rather than simply foreclose and takeover:
All of these are designed to avoid the worst-case scenario where the borrower simply defaults and walks away, bank forecloses and is left with a half-built building - in that scenario, then yeah, we're looking at the value of the land and improvements and hoping to god our basis (LTV/LTC) isn't so high that we're totally underwater. Honestly I've never seen this scenario play out (doesn't mean it doesn't happen), so I'm not sure what specifically the process is. I know it goes to another division of the bank and I assume they try to liquidate what they can.
Just a note for those wondering; it’s usually the final portion of the sizing “60% as stabilized LTV” which lowers proceeds and hurts borrowers. Subjective and based on the appraisal you get.
Yes, good point. A lot could be improved with the lending/appraisal process, but unfortunately it's heavily driven by regulation (FDICIA and FIRREA). Some of the stuff I see in appraisals are flat out dumb, and sometimes stay in the report even after I provide lender comments. I definitely sympathize with borrowers on this
Side question here. At a debt fund but don’t do construction. For guys on that side, are construction lending debt funds able to lever their loan (ie line lender advance etc)? If so, what type of advance % ballpark? How does it work w the lower day 1 funding and ongoing / constant loan fundings (construction draws/loan increases as the projects moves forward)? Thanks
Are you asking if there are warehouse lines with 80% advance rates etc where funds can tap when they originate their ground up construction note? I’ve only been exposed to semi/heavy transitional. If that’s what you’re asking I’m curious too.
Lender financing is harder if it is fully groud up construction, but not impossible (lender charges more and therefore can pay more to a leverage source).
Most leverage will fund their advance against whatever opb is. So as draws occur, you can ask your leverage to fund additional dollars as well.
Gotcha helpful thank you
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