For families wanting to build their dream home, as well as developers planning their next major venture, borrowing money to finance the undertaking is both necessary and advantageous in most situations. Lenders are a quiet, yet vital part of almost every construction project.
1. Structuring the Loans & Choosing a Lender
One of the first decisions to be made in construction is how best to structure the loans. Homeowners, for example, must decide between obtaining interim financing and thereafter, a separate long-term mortgage, or to combine both those loans into a single package.
Different lenders may offer different services here: some may be interested in offering either option; others may offer only interim financing or only long-term permanent loans. Shopping for a lender can be a lengthy and complicated process; however, choosing the right lender is extremely important to the success of any construction project. For a smooth and successful result, a savvy and resourceful lender is imperative.
What is the best way to find a lender? Over time, many construction professionals built relationships with various financial institutions, based upon years of successful partnerships in the past. Home builders of a certain size, in some parts of the country, may also offer financial assistance to the home owners as they have affiliated entities to provide lending as well as construction services. Today, however, the adage remains true: the best way to find a lender is to ask around, and discover a local institution with a good reputation through simple word of mouth.
2. Types of Financing
A. Interim Financing – “Story Loans”
With interim financing, a loan is created to cover the construction phase. The entire amount of the loan will be due in a short time frame, i.e., when the project is finished.
The term of the loan begins on the day the loan documents are signed. Funding is distributed as the home is built, with the lender, the builder, and the borrower jointly deciding how best the cash will be physically distributed. Oftentimes, a separate checking account is set up for just this purpose: at certain intervals, the lender deposits a sum into the account, with the borrower then distributing those funds as needed. If construction delays cause the project to go past deadline, the loan can be extended, usually for a set fee established in the original loan documents.
Lenders are extremely involved with any construction project where they are providing interim financing. Understandably, these types of construction loans are unique to the particular project, and the lender will want detailed information about the venture, not only before they decide to lend the money, but also during every step of the building process. In fact, lenders want to know so much minute detail about their interim financial projects that these loans have come to be known as “story loans,” since the lender “knows the whole story” of the project.
As for the cost of money involved, there is usually a variable interest rate for interim financing with a higher rate paid on the interim loan correlating to a better rate deal on the permanent financing. Borrowers make interest-only payments during the construction; the full amount is only due after the project’s completion.
Start-up construction costs are covered as part of the initial funding; thereafter, the lender will usually require a copy of the building permit as well as a set percentage of the construction being completed before any more money will be released. How does the lender determine this percentage?
During construction, representatives of the lender will inspect the construction site. These are usually supplied by third party companies who specialize in this type of work.
The lender’s inspector will approve distribution of funds for “board and nails” costs based upon an inspected percentage of construction completed. In this way, the lender protects itself against a stalled or out-of-control project by staggering the amount of loan monies released in tandem with the construction’s progress. Lenders will also provide deposits for those items that require custom craftsmanship — such as windows, doors, flooring, and custom lighting.
As construction progresses, financing continues on a step-by-step basis. Usually, lenders issues two draws per month, based upon their inspector’s recommendations.
The final 10% of the interim construction loan is usually held by the lender at the end of the project until verification is provided that no liens exist against the property and that the owner has good and proper title. This may also be contingent upon providing proof that long-term financing is in place to cover the amount of the interim construction loan. At that time, the remainder of the loan is funded, and the entirety of the interim financing will thereafter be due, in lump sum, on a specific date – usually within three years of the signature date on the loan documents.
B. Long Term Real Estate Loans – Residential and Commercial
For any loan secured by land (and its improvements) as its collateral, there are two basic distinctions: residential real estate loans are treated differently than commercial ones. As for the lenders, there are a wide variety of financial sources who view real estate loans as worthy investments because of the interest income they provide over time. Real estate loans have been financed by private individuals, as well as banks, savings & loan associations, credit unions, mortgage bankers, pension funds, and insurance agencies.
1. Residential Real Estate Loans
Residential real estate loans (“mortgages”) finance homes for personal use or for rental income. The lender provides a lump sum to the borrower, and that sum is paid back over a long time period, together with interest. The interest rate can be fixed, or adjusted, and the financing institution makes its profit on the interest income it receives over time.
Residential real estate lending is somewhat standardized, with creativity in the past few years being focused upon the adjustable interest rate mortgage and the resulting sub-prime mortgage crisis of the past two years.
2. Commercial Real Estate Loans
Commercial real estate loans finance land (and its improvements) that will be used for commercial, or profit-making, purposes. Apartment complexes, shopping malls, storage warehouses, car washes, and restaurants are backed by commercial lending.
Commercial lending is much more creative and complex. Real estate investment loans in the commercial area include not only short term loans as well as long term ones, but mezzanine financing, foreclosure investor money, permanent debt, equity financing, and hard money loans.
For example, home builders often place their personal financial security at risk as they borrow money to build homes to sell in the marketplace. The builder typically faces a lender that will cover 80% of the cost to build the to-be-sold house, with the builder’s personal guaranty, leaving the builder with a 20% cash gap — he’ll have to have that amount in order to build the home, and the profit from the sale will need to cover his cash outlay plus the full amount of the commercial loan. This number exponentially increases for each to-be-sold house he plans to build: he’ll need much more cash if he’s building 100 houses as opposed to 10, and the builder will also need to have capital in hand to cover subcontractor and supplier payments during the construction process.
While the home builder will recover these financing costs, theoretically, in the sale of his completed homes, he will need to find creative ways to deal with the financial realities not only to maximize his profit, but t
o protect him personally against financial ruin.
One example of how a builder might minimize his risk in this situation is by sharing it. Commercial real estate investment trusts (REITs) are legal entities recognized under the Internal Revenue Code that either invest in different kinds of real estate or real estate-related assets. Individuals invest in the REIT and receive a return on their investment through its profits. Some REITS own all or part of a real estate project (such as a shopping center or a hotel) and make money off the rents; other REITs lend money to owners and developers and make money off the interest; and still other REITS combine the two as “hybrids,” acting as both an equity and a mortgage REIT.
In order to qualify as a REIT for federal income tax purposes, a company must pay 90% of its taxable income to its shareholders each year; invest at least 75% of its assets in real estate; and make at least 75% of its gross income from its real estate holdings (either in equity and/or in mortgages).
C. Finding Financing – the Impact of the 2007-2008 Sub-Prime Crisis
1. What’s Happening
In 2007, foreclosure activity across the United States was 79% higher than in 2006, and in December 2007, The Economist estimated that sub-prime defaults would reach between $200 and $300 billion in 2008. What’s happening here?
First, housing prices dropped in 2006 in many parts of the country — leaving many home owners facing adjustable rate mortgages that would be increasing monthly payment amounts as the interest rate rose, as well as a simultaneous inability to refinance for more favorable terms due to the lesser value of their home. Defaults on residential home loans skyrocketed.
Second, the lenders who held those mortgages took a loss, as the borrowers could not pay their mortgage payments. Major, well-known financial institutions announced huge losses — as of February 2008, totalling $140 billion.
Third, for those corporate and institutional investors who had bought the rights to those mortgage payments via mortgage-backed securities and collateralized debt obligations, their assets were rapidly declining in value along with their stocks. This hit the U.S. stock market, as well as those in other countries, in a significant way.
2. Impact on Owners, Contractors, and Lenders
In response to all this activity, lenders have become less willing to make loans, or have started offering loans at higher interest rates. Economic growth has slowed overall, but especially in the housing market.
Currently, there is a surplus of new homes setting in builder inventories across the country, making it harder for home builders to tread water in the home construction business. For example, D.R. Horton and Pulte Homes are being severely impacted by the current economic pressures and declining new home demand.
Likewise, suppliers are feeling the impact. For example, Home Depot’s profits in the past have depended upon construction and Home Depot has announced that it foresees its 2007 earnings to fall by as much as 18% per share, which is much larger than their 2006 estimate.
The good news may be for those involved in constructing apartments — renting is becoming more popular as buying homes becomes less viable. REITs that own or operate apartment complexes should be increasing in popularity. The construction of luxury apartments, and family-oriented apartment complexes, should be on the rise.