Advice Needed - Multifamily Construction Financing

Hi, 

My firm is considering a construction loan on a multifamily project. We are new to the construction financing arena and could use some advice.

The project is self-financed (no waterfall), the land value is about 5m and the construction hard and soft costs are about 10m. 

i.e. if 75% LTC is given, does that mean we can borrow up to 75% of 15m = 11.25m? In other words we would be able to borrow more than the hard costs? What rate/terms are typical?

Also, what does the land value mean to the lender, being quite high at 50% of hard costs? Does this provide greater collateral or better lending terms?

Any insight or advice is greatly appreciated. The project is in the LA area. 

Thanks!

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Comments (14)

Most Helpful
Nov 14, 2021 - 8:47am

Good question. I work in affordable housing development, which has more layers of financing, but I think for you, the short answer is, it depends on your operating pro forma at stabilization. In other words, is your perm mortgage big enough to take out all that construction debt plus interest? Example: say at stabilization your deal's NOI is $1M. Let's say the perm lender requires a DSCR of 1.25 at Year 1, so your maximum debt service is constrained to $800K annually by DSCR covenant. Then look at LTV: let's say you use a 5% cap rate and your project is worth $20M as stabilized. At a 75% LTV your principal is constrained to $15M. Plug your lender's interest rate and amort and goal seek your highest debt service. In my example using a 15-year amort and a 3.5% rate your maximum principal would be about $9.25M based on that $800K annual debt service limit.

This is purely an example, give us some more numbers if you want to take a deeper dive. Lastly there is your question of whether all these costs are even eligible. The answer is probably not, at least not at a very high level of risk for the lender. In other words, they aren't going to lend you 75% LTV on your land or your soft costs because there is the question of collateral risk. High land prices are riskier, not the other way around. Hard costs including materials will get the lender a bit more comfortable. In affordable, there are requirements about eligible costs, but you won't have to worry about that here: just worry about what your banker is telling you. I'd call a couple lenders and just run it by them. I'm guessing they will lend you maybe 50% of TDC given the crazy land valuation and whatever risk is tied up in your rent increase assumptions and trending expenses. Before you make that call to your lenders, make sure you understand these variables and how they relate to each other.

Now about the reality of your proposal. Regarding the deal itself, my two cents without knowing anything about your project is that your land costs are exorbitantly high. 1/3 of TDC? How did you value the land? I'm guessing you are planning to build maybe 25 units? Land is $200K/buildable unit? Even at $3,500/unit, with a 50% expense ratio that's perhaps $500K in annual revenue. Let's say you operate at a 30% ER, so you are at $700K in NOI. Let's pretend that in two years cap rates will be 6%. A lender will add some cushion, so let's go with 6% as a hopeful estimate. That's a stabilized value under $12M, $3M lower than your TDC. Give me real numbers and I'll dig into it if you want - but my back of the envelope shows that this deal doesn't really work.

Sure, you can underwrite juiced rents at +4.5%/year and expenses at +2%/year and a 4% cap rate, etc. etc., but the lender isn't going to buy it, at least I would hope not. More importantly, your organization would probably be losing out on a LOT of $ and time if my numbers are ballpark correct. Of course, if you are building twice as many units, I would be completely wrong and the deal would work very well. But, that would equate to $200K/unit in hard and soft costs, which is unbelievably low, particularly in our hyper-inflationary environment. 

You said you are new to construction financing. That's a BIG red flag for lenders, particularly in such an over-heated market. It's also probably why you are self-funded this time around - a savvy investor will see your inexperience as very risky as well, and pass on your first time. Guessing you are using this opportunity to showcase your ability to run these projects. Be careful. Think of it simply: you are paying $15M to create an asset that is going to be worth a multiple of its revenue. If its revenue is going to be $750K, at a low 5% cap rate, then 2 years later you will break even (but really you will be losing time and money). Did you already buy the land, at LOI, under P&S?

  • VP in RE - Comm
Nov 15, 2021 - 1:17pm

Thanks for your input - I left you a DM as well. 

The land is owned by the co at a very low cost basis. The valuation is not from appraisal, but our best guess of market value. We figure the NOI might be close to $1m with 35 units and a large commercial space on the ground floor with a tenant already interested. (35 units at avg rents of $2500 x 30% expenses, plus the NNN retail lease). At a 5% cap rate that would value the project around $20m+. Owners are hoping to hold the asset long term and pay down the debt over time. 

There is an existing retail structure on the site which can be immediately leased for around $200k+ NNN, hence the high land value. 

We have had a tough time getting good cost estimates from contractors without signing them up for precon services (they are busy), but hope to hard bid the drawings to several firms once they are finished. 

Any lenders/brokers you would recommend for multifamily in the LA area? We figured we would at least entitle the site first, then start talks with lenders, but the design hinges on how much we can build as well, so getting an idea of a maximum loan would help us now as well. 

A second option is to JV with a larger firm on the site - however given talks with other firms in the past, many of them want to build a giant project at inflated costs (over double what we have planned). We feel this would dilute our land value equity too much and our NOI would be too low. 

Thanks again for your help. Let me know about my DM as well. 

Nov 15, 2021 - 2:18pm

So the lender is not going to account for the existing retail structure in your proforma land value - they'll treat it as zoned land and assume any entitlement costs are carried in that land value. This would typically be valued on expected/approved density. The existing retail structure is irrelevant. So you need to get an idea of what land sells for on a buildable square footage basis in your market.

In terms of exit cap, I can't speak for smaller scale projects like this but for larger projects from reputable developers with a track record and strong balance sheet I've seen lenders underwriting loans at only 25bps premiums over market in strong markets.

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Nov 17, 2021 - 7:21am

No problem. As CREnadian said you aren't going to get collateral credit on a retail structure if you are going to tear it down. Since you already own the land at a low cost basis, let's not worry about it. You need to scrutinize your hard costs, IMHO. They seem low, but I am admittedly on the other coast so things like labor could be cheaper where you are. You should ask some GC's what it is costing to build [4-story stick or whatever] in your market these days on a PPSF and PPU basis. Sounds like you need someone who is more connected to the construction world out there, much better to just pick up the phone to start out. IDK the size of your units or the quality of finishes, etc., but you are currently projecting under $300K/unit for hard and soft costs which could be low. What is the gross square footage projected to be? Do you have onsite ground level parking or is it sub-grade/structural? I assume there are strict parking space per unit requirements per zoning ordinance for both resi and retail. Is there parking income from the residential? Did you price in parking and make an allowance for it in the building gross SF? Do you have a zoning analysis from an architect? You'll also want to sort out what kind of guaranty is your lender is looking for from the principals and gauge their comfort level. I don't know local lenders out there, I'm in the northeast, but I would start chatting with them about your proposal sooner than later and they can ideally tell you what risk elements they are concerned with. Have you guys considered building it, leasing it up, and selling it immediately? That might make more sense from an IRR perspective, particularly if you have another asset to roll the equity gains into. In other words, the mortgage is probably going to eat up a majority of the cash flow from this asset. Meanwhile the physical plant is depreciating. If you can build something for let's say $15M and sell it for $20M without making a single payment of P&I, why wouldn't you? Your alternative is operating an asset for cash flow of what, $150K/year after DS if you are lucky? Throw in tax benefits from losses and you are still not making much compared to just selling the thing is my guess. This isn't really advice, just food for thought as you consider the options.

Nov 14, 2021 - 8:45pm

Some other thoughts:

1. Lender will ask is land value market. Have you owned it for a while and you're marking it up? Are you paying too much for it? If it is true representation of market and you are just buying land that will be more favorable.

2. Expect partial or full payment recourse that partially burns down on CofO

  • VP in RE - Comm
Nov 15, 2021 - 1:16pm

Thanks. The land is already owned by the firm at a low basis from years ago. The 5m number is our best guess of market value, but figure the appraisal will come in lower (maybe 30% lower? Not sure how lenders appraise usually). 

Do you mean lenders will not offer non-recourse construction loans on a project like this? 

Nov 15, 2021 - 2:07pm

I don't think you'll get non-recourse at 75%. I also think (i) lenders will use the appraised value of land, not what you're giving them and (ii) even an appraised value they will be careful about if it isn't equal to your cost

  • VP in RE - Comm
Nov 17, 2021 - 3:11pm

The site is in a TOC area so we know the max # of units and retail space allowable. SNAP guidelines supersede the TOC law so that limits our density - wish LA city would get rid of the SNAP already. We have been told most TOC projects will receive approvals within 9 months. Question is whether we can afford to max out the entitlements given our land value/loan size.

Nov 17, 2021 - 10:16am

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