Acquiring access to capital is the prevailing challenge for commercial real estate developers today. Interest rates have doubled in the last 12 months, a banking crisis has catalyzed a liquidity crunch, and interest rate volatility has made it nearly impossible for developers to price a deal. In short: the constrained capital environment has suppressed lending activity. In the first quarter of 2023, loan origination volumes fell 56% year-over-year, according to data from the Mortgage Bankers Association.
Ed Chazen, a senior lecturer at Boston College’s Carroll School of Management and an expert on the commercial real estate investment market, expects reduced loan origination volumes to be the norm for the near term. “I think we're going to be in an environment for probably the next three years where leverage levels are going to be lower,” Chazen said in a special interview with Northspyre. “That means if you want to stay alive in the real estate business, you need to have more equity behind you or partner with an investor.”
While acquisition loans are driving the depression in origination activity, construction loans, on the other hand, could help to fill the void. In January, Real Estate Capital USA predicted that construction loans will account for a bulk of the big-ticket lending this year, while acquisitions priced at $100 million or more will decrease. Although there remains opportunity to secure construction financing, lenders are heavily scrutinizing deals. Here are four key techniques developers can use to create a strong deal that catches investor attention and wins funding.
Strong Underwriting
It may sound obvious, but strong underwriting is essential to securing funding in the current environment. In a bull market, lenders have confidence that developers can meet pro forma pricing. However, during a bear market, developers have an obligation to tell the story of the construction project and educate the lender on the local market dynamics supporting the development. This means developers need to show prospective lenders evidence of healthy demand fundamentals, including rent surveys, occupancy trends in the immediate market, quality of location and even land pricing to prove the viability of the deal.
Developers should aim to build lender confidence in every component of their project, both during construction and stabilization, to ensure comfortability in creating a successful financial partnership and pursuing the deal. In addition to the location and the project’s potential, developers must also disclose detailed construction budgets and outlines, including prospective general contractors.
Developers utilizing construction management automation have an opportunity to gain ground in this presentation. Automation and robotic intelligence with programs like Northspyre help to reduce budgets and respond quickly to market changes. This technology elevates lender confidence and enhances downside protection.
Commitment to the Deal
When market fundamentals deteriorate, lenders fear that developers will abandon a construction project. To instill confidence into the deal, developers must have skin in the game. Lenders will expect a substantial equity stake in the development project with a lower loan-to-cost ratio. Developers should expect to increase the typical 20% down payment to 25% or even 30% in a challenging market. Increasing the equity commitment will show lenders a high level of dedication to the project.
In addition to increasing up-front cash, developers can also show a strong track record of successful developments—a sign that the organization has a history of crossing the finish line—along with past financial records that illustrate quality stewardship of a large-scale project. Any added connection to the development project, like a history with the community, should also be communicated to the lender. Each of these factors illustrate a deep commitment to the project.
Demonstrate Stability
Seasoned developers know that every real estate project will face unexpected challenges or delays that can impact the budget. A study from Procore Technologies found that 75% of commercial developers exceed the initial budget and 77% delivered projects late, which also incurs increased carry costs. These problems have become a standard expectation in commercial real estate development, and lenders want to partner with developers who are able to absorb overages into the project.
Developers with a strong track record and robust cash reserves can absorb these costs, but forward-looking developers are leveraging technology to reduce overages altogether. Predictive analytic technologies can anticipate and forecast construction complications and delays, giving developers an opportunity to adapt and respond to changes before they impact a project’s budget or schedule. With Northspyre, developers have experienced reductions in budget overages of 66%. By combining this technology with a stable operating platform, savvy developers will have no problem assuaging lender concerns about overages.
Find Alternative Loan Products
When a conventional loan program isn’t a fit, developers still have options. Many opportunities exist to secure funding through alternative products. In a volatile market, like the one we have today, rate-lock programs are wildly popular and tremendously valuable. As the name suggests, a rate-lock program allows developers to lock in the rate through the due diligence process, serving as a valuable tool to combat interest rate volatility. There are various construction loans that are rate-lock eligible. Multifamily developers, for example, can take advantage of Freddie Mac’s Lease-Up loan product, which lets the developer lock in a rate and secure funding before stabilization is complete.
Green loan programs are another option. This structure is widely available to help developers secure funding, often at attractive terms, if their project meets specific sustainability requirements. Developers focused on specialty assets, like affordable housing, nursing facilities or life science properties, will also find specialty lenders or programs targeting those assets. Specialty loan programs are an excellent opportunity for developers to secure funding at an attractive rate.
The current lending environment is undeniably challenging—but there is liquidity available to fund deals. By establishing quality and conservative underwriting standards, building trust with prospective lenders, and using technology to mitigate downside risk, developers will have no problem securing it.
Want to learn more about minimizing project risk and increasing profits during a market down cycle? In Maximizing Returns: A Real Estate Developer Recession Guide, get the insights you need into today’s economic climate and how you can create a defensive strategy to successfully navigate it.
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Real Estate Development