Think about the last time you saw a construction crane or a six-foot chain-link fence surrounding a construction site; to some, it signals economic progress and opportunity to move a business to the newest property on the block while to others, it signals an opportunity to buy a project at a bargain price in the months to come.
For banks, many are buried in their underwriting files reviewing the appraisals and feasibility studies they once used when underwriting pre-COVID construction loans.
Why? Because most construction loans are made by commercial banks; they prefer short term construction loans as the bank earns upfront loan fees of up to 2% on the face amount of the loan, when in reality, only about of 60% of the loan proceeds are outstanding at any one time over the loan term.
On the surface, the yield looks great. Yet historically, acquisition, development, and construction loans (ADC) have always been the most-risky type of real estate loan, and the type of loan that contributed highly to the failure of over 500 banks during the Great Recession. In my four assignments as a testifying expert in four bank failure cases, circa 2011-2013, the final blow to each bank’s solvency was dealt by defaulted ADC loans.
Looking at the construction loan underwriting side, FDIC guidelines in recent years suggest that banks should consider (i) feasibility studies and sensitivity analyses, (ii) pre-leasing requirements, (iii) analyses of the global cash flow of guarantors, (iv) hard equity, (v) limited use of interest reserves, and, in some cases, (vi) whether a takeout loan exists.
Now consider that a construction lender abided by all the underwriting recommendations of the FDIC during the 2018 and 2019 period, and in fact, complied with all the mentioned analytical considerations.
At the point of underwriting, the lender had the comfort that portions of the property were pre-leased, that the remaining space would be leased during or shortly after construction completion, that the anticipated rental rates would be achieved, that the borrower had sufficient cash on hand to bridge any shortfalls, and that a takeout lender stood ready to takeout the construction loan upon completion. That would cohere into a perfect credit world for any lender.
But today, the real estate world as we know it due to COVID will negatively affect the financial integrity and success of hundreds of construction projects nationwide. Simply put, the original underwriting metrics used to size the loan and set its financial terms will not be achieved. As we move into 4Q 2020, no one expects pre-leasing commitments to hold as originally negotiated; no one expects the same rental revenue previously programmed; developer’s equity and cash on hand is drying up due to cash flow demands from other properties; takeout lenders can be expected to look to void their commitments due to the deteriorating financial dynamics of certain real estate asset classes; and, expect untimely construction completions and incomplete lease-ups.
In vivid flashback, my first five-hour deposition in 1973, as a construction loan officer came during litigation brought by my bank employer against a lender who walked from a takeout commitment on a budget motel in Orlando. In short, when the delayed motel was opened, it underperformed relative to the original underwriting, and the takeout lender walked. My bank came up short in that case.
Fast forward and consider projects under construction now. According to STR Reports, 220,000 hotel rooms were under construction in April 2020. The major construction markets for hotel construction at that time were New York City, Dallas, Houston, Atlanta, and Nashville. Then on to retail, where according to CoStar Data, there was just under 80 million square feet of retail centers under construction in 2019; top markets were Houston, Long Island, Northern New Jersey, Dallas, and Miami at that time. Then, to office construction where the National Real Estate Investor reported that approximately 110 million square feet of office space was under construction in 2019.
If you consider how each of these asset classes has deteriorated in the last six months, including the fact that (i) business and leisure travel will be down until herd immunity is achieved, (ii) office use will contract due to the success realized by businesses during work-from-home edicts, and (iii) retail which was already suffering pre-COVID, you have the makings of troubled times ahead.
The projects mentioned above and many others now under construction may be completed over the next 9-24 months. Hence developers, loan guarantors, and lenders are staring at a Time Bomb. All concerned will soon hear the ticking.
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