What Happens to Smaller Construction Lenders When Values Drop from Initial UW
Hey guys,
What happens to smaller construction lenders and their loans when were going into a down market and values drop. An example is pre-construction you value the deal at $100mm and today years later it's worth $80mm.
Does that just mean the lenders balance sheet has been reduced? Also is the way this work is let's say they raise funds to deploy. They had $1 billion to deploy of investor capital (so HNWI, pension funds) and used $100mm of that for this loan. What happens on the equity side when the lender has to revise the current value and that it didn't hit expectations, does $20mm just disappear and investors are like wtf? Or are they promised a certain return (lets say 5% to make the math easy). So the lender pays the HNWI/PF $500k for that $100mm and have to make payments on it meanwhile the developer has their own rate, let's say 7% and the lender is still making that spread even at the $80mm value and is only an issue if the owner has to sell? What happens if this drop in value occurs over multiple loans in the portfolio and the initial $1 billion is now worth $700mm? What happens when the construction loan is repaid, so this $100mm loan after 2-3 years depending on terms is repaid so they lender gets interest + the $100mm is that dispersed to investors and the lender gets interest + fees for their part?
If anyone could give a better overview/example of a debt fund that would be helpful.
From reading this I honestly think you should start with what a loan is. You're moving between lenders, debt funds (who are lenders, but not all lenders are debt funds), and equity that it's almost impossible to understand what you're asking. That said, here's a stab at what I think you're asking:
Let's say someone wants to build a building that will cost $100. They get $40 of equity and they find a lender to give them the other $60 at a 5% interest rate (non-compounding for simplicity). For simplicity say it all goes in up front. The lender then earns 5%/year on the money that they lent.
Three years later the building is completed, leased up, etc. and then sold for $90 (assuming closing costs, etc. are $0). The lender is owed $69 ($60 in principal and the 5% of interest annually) and is paid first. That leaves $21 that is returned to the equity shareholders for a ~50% loss.
As an alternative, let's say the building was sold for $60 (probably went through a workout, etc.), the lender, or whomever holds the note at that time, then recoups $60 and takes a loss of $9 on the interest that they were owed. The equity shareholders get a return of $0.
Hope this helps.
I think your question is more about the actual value of the property and the permanent financing needing to secure it at the end? Construction loans are going to be based on the build cost which can change over time.
I work on the GP side at a developer and deal with several construction loans we have for all of our projects. The principal of the construction loan is not all disbursed at the beginning of the project. Portions of the principal are disbursed over time as we complete phases of the project. These are called draws. After some time we complete the foundation draw on that cost from the loan, the principal then grows by that amount. Next phase, complete the framing, draw on that costs to the loan and so forth with the next phases. So our principal grows over time and the interest payments made at the start and at the end are not the same. We also might not draw the entire loan amount by the end of the project because we found ourselves under budget at $80 million vs $100 million. I don't work on projects of that scale but being 20 percent under budget is a godsend, but i'd really call that a wish for right now because some materials like lumber have gone up in costs since 2019 and only in the last 6 months have they begun to swing down at a steady rate, so coming being over budget was more common than under budget in the last 24 months.
I don't know much about the optics of how it works with the holders (debt fund) of the construction loan but hope this perspective as the borrower helps.
Thanks, definitely helps. My post simplified it too much, but I understand how it works with draws and paying interest on proceeds used, submitting recs to the lender. I was more focused on what happens from the lender's perspective in these situations (drops in value) because I’m interviewing at one and they focus on construction lending and this doesn’t seem like the best market to be getting new construction loans so I was thinking on the originations/UW it would be slower and more AM of existing.
getting a new construction loan right now a good idea? that's a good question. Less favorable loan terms deter us, but we'll be in a different market once we do complete the project because of how long construction takes, so does it make sense to hold off and get no construction loan for today?
So why would a lender provide favorable loan terms to you now? Interest rates are insane, I know construction loans can be fixed but from what I've seen they're usually floating rate. With an expected rate increase later this week, that would push those higher so it seems lenders are getting screwed on this and can't cover it by passing it on the borrower why would anyone in your position take a loan right now unless you had to. Right? Because are you really going to pay SOFR + x00. If construction rates were say 6-7% before they have to go up no, I'm still new but has anyone ever paid 10%+ for a majority of their construction debt if not more?
funny you mention those rates because there's two projects i'm working on. Both are identical, one locked at a fixed rate just under 7 percent at the beginning of May, the other is basically the exact same project, locked at a floating rate 7 percent plus 3 month SOFR and a floor of 9 percent. That one closed at the start of August. So we're paying close to that 10 percent. We had to move on it because the project got approved after more than a year. There were already significant costs involved at that point, that delaying construction didn't make sense, we only know rates will continue to become higher.
It really only affects loans maturing in the short term, or however long it takes real estate values to bounce back. It affects borrowers in that they now have a $100mm obligation and only an $80mm asset. They cannot refinance the entire amount so they need to either put equity in, sell the asset (hopefully for more than outstanding balance), or go into default. When interest rates start to rise and asset values begin to decrease, defaults will naturally rise and lenders will begin to pull back on lending activity as they readjust their portfolios to decrease exposure to riskier loans.
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