I was reading an industry magazine the other day and came across something very funny. A little shocking, too. A very popular mortgage lending resource aggressively advised mortgage brokers to stay away from construction loans. Unbelievable! Their argument was that you will spend too much time for nothing – that they aren’t closable. This was funny because I NEVER turn away construction loans. They represent a solid 25-30% of my business. In this economy, there are many good loans out there where the original construction has stalled due to lack of funding. They are problems begging for solutions. Frankly, if I were going to only do one kind of loan, it would easily be construction loans.
Why? Keep reading…
Five Reasons Why You WANT to Broker Construction Loans
Real estate investors, small business owners and other types of Borrowers would like to close their commercial loans (note my emphasis); Builders and Developers MUST close their loans. That’s how they make their living…which makes it a good way for you to make your living. As opposed to a good way to earn some income and build long-term wealth, Builders and Contractors need construction activity to put food on their table. In this market, some construction activity is continuing in most markets and many projects have stalled because of lack of institutional capital. You can be the key to helping them feed their families. That’s where you can profit.
Also, in my experience, most Builders are experienced enough as Borrowers so as to not require a lot of “training” from the Broker. True, many are not accustomed to working with Brokers to raise money for their projects. They are still in shock that they can’t get funding from traditional banking sources. However, they are experienced as it pertains to helping you compile everything you’ll need on your Lender’s loan checklist.
On the other hand, a lot of commercial borrowers require a lot of time – turning the Broker into a Teacher, as well – because they have only previously been exposed to borrowing for their home loan. I have never had a Builder ask me what an MAI Appraisal is, why they need one or why they cost more. That means that my job is often just a matter of packaging the loan request well and locating a money source. This is much more time-efficient than educating a Borrower along the way.
You will find many such projects are not as interest rate and financing charge sensitive – giving you considerable range in developing a funding strategy.
Finally, closing construction loans for small to mid-sized commercial projects has another benefit: you often get the first opportunity to close the permanent mortgage! There are two approaches to this step. One, you can hope to have earned your shot by having been successful at closing the very difficult construction. Or, you can ask for a Fee Agreement that covers both phases of the project at the beginning, if you’re confident that you can bring the entire financing package together. This is one of the most exciting aspects of working on commercial loans in my practice.
So, have I convinced you that construction lending makes sense? Good! What’s next?
Where Do You Start?
To be fair, most Brokers can protect their reputations by staying away from construction loans. They can be tricky and there’s no reason to ruin your business and someone else’s by performing what I call lending malpractice. However, if you’re going to do construction loan brokering, you will want to know the answers to these three questions:
1 Where can you find the better Clients?
2 How can you determine quickly whether you have a good deal?
3 How can you package a construction loan request so that Lenders will respond?
In this article, I will address each of those questions in a way that I hope will give you tools that you can use to be more successful as a mortgage professional. Now, let’s tackle the burning questions.
Where can you find the better Clients?
I have found the best Builder contacts through three primary sources:
1 – Local builders associations: You can offer to present a seminar to the local builders association. I have done this for builders and for other brokers. As a general rule, you may not get hundreds of people to attend, but those who do will have a deal to discuss with you…usually right after your presentation! Therefore, take someone to help you or be prepared to spend more time after your presentation than your presentation takes.
2 – Local community banks: Contact a local banker and ask for “turn-downs” that don’t fit their programs. In this market, bankers are friendlier about asking for help with loans that are in their pipelines. As Woody Allen said, 90% of the success here is in the showing up. Taking a business card or two to your bank can work wonders.
3 – Project signs: Place a call wherever you see a sign for a project that is “Coming Soon” but where construction hasn’t started for some time. Most of the time, these developers haven’t secured their financing, so they haven’t been able to begin construction. The project has languished and they’re frustrated. Be prepared to prove your determination. After all, they have probably dealt with a lot of disappointment by the time you call. If you can demonstrate some energy, you may be able to win an exciting engagement.
All three approaches will yield fruit for you and teach you something unique about the business. Remember, you don’t need a lot of deals to get your feet wet. You just need two or three in your pipeline on which you can focus and learn your way around these types of loans. It only takes a couple for you to begin to understand what factors make a deal strong. In the interim, let’s look at a few keys to protecting your time and increasing your chances of success by being able to determine whether you have a loan that can be closed.
How can you determine quickly whether you have a good deal?
Construction money is tighter than ever before. Loans are still being made, but with the competition for the dollars increased, Lenders are scrutinizing the packages more closely. Here are the determinants that I see most often considered:
1 – Builder’s Background – Has your Builder ever completed the type of project that they are working on now? If not, they may not be as familiar as they should be with the material costs and timelines involved and the lender will, rightly, be concerned. This happens a lot when homebuilders begin to take on commercial projects. Sometimes, your Client may have to bolster their project team by bringing in someone who has the needed experience.
2 – Exit Strategy – The most important element of getting something built is getting it sold. In my experience, this is the most forgotten aspect of a Builder’s business plan. Very few plan or budget for sales and marketing. They think “if they build it, they will come.” If your Client hasn’t put real plans in place to market their product, you might have to remind them to get supporting letters from Realtors, local officials, potential buyers, etc. This is even more convincing if the future customers will put down cash deposits.
3 – Construction Budget – Many bankers feel as if they contributed to this real estate downturn by simply approving loans that they should not have. Construction loans were no different. A lot of loans – both residential and commercial – were allowed to move forward at LTV’s and LTC’s that should have been considered out-of-bounds. There are three considerations here as regards to construction budgets:
a) LTV Guidelines
b) LTC Guidelines
c) Elements of the Budget Itself
LTV/ Loan-to-Value – Most construction lenders will provide a percentage, usually from 60% to 80%, of the completed value of the property in the form of a construction loan. This is accomplished by obtaining a trustworthy appraisal during the underwriting and loan evaluation process. Once the value is determined, a Lender will judge that the project can be completed by a reasonable contractor at a percentage substantially below the final value. LTV’s are lower for funded loans than they have been in some time.
LTC/Loan-to-Cost – Along with LTV, some Lenders will constrain their construction loan to anywhere from 80% to 90% loan-to-cost for smaller projects. For larger projects, bankers are approving LTC’s that are even lower. For your Client, it means that, even if they have projected that their project can be completed within reasonable LTV guidelines, the Lender may still want them to have significant “skin in the game” by bringing a portion of the hard costs to the closing table. For the most part, the days are gone where the Lenders are comfortable being “the only money coming to the table” even on the most promising of loan scenarios.
Budget Ratios – When you review the construction budget, the numbers need to be in line as a percentage of the total construction budget. They can vary a little, but be careful that they don’t veer off too much. Any residential builder’s numbers should fit as follows:
Raw Land Cost 14.5%
Lot Improvements 11.5%
Materials 24.3%
Labor 20.3%
Builder Overhead 7.6%
Financing Charges 4.3%
Marketing & Sales 6.1%
Advertising 3.1%
Builder Profit 8.3%
Total Construction Budget 100%
These approximations have been distilled from Various Sources, including “Professional Builder Magazine” and several builders and construction lenders that I have worked with over the years. Or, to look at this in a more simplified fashion, you can follow the “25/50/25 Rule” meaning that you allocate:
• About 25% of the total project for Land and Land Improvements
• About 50% for hard costs including Labor and Materials
• About 25% for all soft costs including overhead, debt service, sales/marketing and builder profit
These numbers can’t be carved into stone…but variances won’t be broad for residential construction loan requests that close either. Generally speaking, if your construction deal doesn’t fit within the boundaries as far as a reasonable LTV’s, LTC’s and internal budget considerations, it won’t close. Even if it would have closed a year or two ago, your likelihood of getting them done for the next couple of years is tremendously low.
Not intimidated yet? Think you have a good loan in your hands? Read on…
How can you package a construction loan request so that Lenders will respond?
Now your task is to craft an Executive Summary that addresses the various risks inherent in construction lending and answers them satisfactorily. The main risks that a Lender will be concerned about are the following:
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Credit Risk – The risk of a borrower not fulfilling his obligations in full on due date or at any time thereafter is a risk that affects all aspects of business.
•
Construction Risk – This is the risk that design and construction clients face when performing as design-builders, or participating in design-build joint ventures. The elements of construction risk include, but are not limited to, performance guarantees, faulty workmanship, injury, damage to owned property and contractual liability.
•
Rate Risk – The possibility of a reduction in the value of a security resulting from a rise in interest rates. With interest rates as low as they have been, some Lenders have valid concerns about possible rate increases on the horizon. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time or by closing the loan at an interest rate that has a premium or “cushion” built into its pricing already. This is common in construction loans.
•
Market Risk - This is the risk to an institution's financial condition resulting from adverse movements in the level or volatility of market prices of interest rate instruments, equities, commodities and currencies. Market risk is usually measured as the potential gain/loss in a position/portfolio that is associated with a price movement of a given probability over a specified time horizon.
•
Business Risk - The risk of unexpected losses arising from deficiencies in a firm's management information, support and control systems and procedures.
•
Legal Risk - The risk that a transaction proves unenforceable in law or because it has been inadequately or improperly documented. Bankruptcies and corporate insolvencies have been a problem for some construction lenders. Therefore, you will rarely see a lender willing to make a loan to an individual any longer. Most of the time, a single-purpose corporate entity will be required for a sizable project.
Your job is to present the loan package in such a way that shows the Lender that any risk factors can be successfully mitigated. What is the strongest of the facet of your loan proposal? The borrower? The property’s current or future value? The project’s future income potential? The exit strategy? Find the strength and accentuate it. Therefore, you should draft a brief (4-5 pages) Executive Summary that covers the following topics:
• Property location and legal description
• Project details and project type such as multi-family, retail center or medical
• Resume and backgrounds of the people involved
• Current status of the project
• Project plans, permits, entitlements and any completed improvements
• Financial projections for the sales or management/leasing of the finished project
• Pictures and location maps for Lenders who want to inspect the property
• Personal and corporate financial statements
• The marketing plan
• The project budget including all land costs, soft costs, hard costs and documentation for any investments already made by the principals
It will take you some time to do a thorough job the first time, but it will become easier with each loan request you structure. As you become more comfortable, you’ll be able to look at a loan prospect in terms of whether you’d be able to draft a good business plan for them from the very beginning. If you notice a lot of gaps up front, you’ll have to decide if you will want to invest any more time to bring the loan package up to your standards.
In Conclusion
Now that you’ve read my advice, I hope you feel more confidence in the area of construction lending. With the credit crunch continuing and bank money harder to obtain, Borrowers who had been able to walk into a bank and walk out with a construction loan are now turning to experienced Brokers to help them obtain funding. In my view, there is no rational reason to take such a large and potentially fruitful segment of the Borrower population and throw it away or ignore it when you can profit from it.
To your success.
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Mark Anthony McCray is a Texas-based mortgage banker. Write
mark@hardmoneyexpert.info or call 281-846-5720.
PS - Also, we have a great educational program available for download for those of you who are looking for guidance in placing commercial loans on your own. It's available here:
http://hardmoneymusings.blogspot.com/2011/08/how-to-broker-commercial-and-hard-money.html
