Construction Conundrum

6 min read

By Anuradha Kher, Online News EditorSince the credit markets froze last year, the multifamily sector has suffered great pains. While financing for acquisitions and refinancing loans has been far easier in the apartment sector with Fannie Mae and Freddie Mac stepping in, the story of construction financing has mirrored that of the other commercial real […]

By Anuradha Kher, Online News EditorSince the credit markets froze last year, the multifamily sector has suffered great pains. While financing for acquisitions and refinancing loans has been far easier in the apartment sector with Fannie Mae and Freddie Mac stepping in, the story of construction financing has mirrored that of the other commercial real estate sectors. New construction has all but halted nationwide, primarily due to lack of credit sources. Also, a drop in demand and the resulting increase in vacancy rates have put an overall dampener on the entire sector.With the fundamentals of the multifamily sector heavily dependent on job growth, this year is proving to be far worse for the sector than last year. The starts figures for example have been consistently falling. After a slight uptick seen in February, multifamily starts were down to 116,000 in March and 78,000 in April, according to the latest reports released by the U.S. Census Bureau and the Department of Housing and Urban Development (HUD). On a year-on-year basis, this is a 55 percent drop. “These are the lowest construction starts since 1953; California and Texas individually had more starts than overall starts right now,” Mark Humphreys, CEO of Humphreys & Partners, tells MHN. “I have heard from some clients that there’s a little loosening of credit now. Instead of 35 percent equity, lenders are asking for 20 percent, which is a big improvement for now. Having said that, the days of projects being over $60 million are over. The only projects that have any chance of getting financing now are the ones in the $35 to $40 million range. Big projects are very tough to get done these days.”With conventional financing or “balance sheet financing” dead, small community banks, some private equity players and most importantly, the US. Department of Housing and Urban Development (HUD) are filling the big gap in new construction financing left behind. HUD helps provide new construction financing by insuring the loans under the Federal Housing Administration (FHA) programs. IN particular, the FHA 221(d)(4) program provides fixed-rate, up-to-40-years-amortizing, financing for the construction/substantial rehab of market-rate (non-rent-regulated) multifamily housing.   “The vast majority of projects taking off right is now funded by FHA,” says Humphreys. The firm currently has about 200 projects or more in different stages of development and that’s not counting the ones that were stalled last year. There is also a large backlog of projects, of which most are awaiting FHA loan approval.KeyBank’s head of FHA financing, Bruce Minchey, says, “No doubt, we have seen an uptick in business. There are a lot of borrowers who had been using conventional financing and are now coming to us for FHA financing. In the good days, it was hard to get their attention to FHA, now they come to us.” In 2009, KeyBank is projecting that it will close FHA loans totaling about $400 million, which is double what the lender used to close in a good year. 2008 was very slow and Key closed deals worth only $100 million. Benefits of FHA FinancingOther than the fact that they are still available, FHA’s construction loans have other benefits. The interest rate for example on a FHA-insured 221(d)(4) mortgage is currently 6.55 percent, not including the mortgage insurance premium (MIP). The MIP would add an additional 45 basis point to the interest cost but this is still very competitive. Also, the construction loan is up to two years, and is interest-only during the construction period. After the construction period, the loan rolls over into a permanent loan. The maximum Loan to Cost is 90 percent of replacement cost value, and the minimum Debt Service Coverage is 1.1. The financing is up-to 40-year fully amortizing, and it is also assumable. The only drawback of FHA financing is that it takes longer to process and while most banks lend based on the concept, HUD requires a lot of details. The initial review by a lender takes two to three days; and the third-party reports take an additional 35 days. HUD’s pre-screening takes about five days, and its subsequent approvals takes a guaranteed maximum of 45 days. During the process of construction, if there are any changes in windows, doors, tiles, HUD requires that the developer inform them formally.“Everything we submit goes through severe underwriting and we only submit the proposals that we think will be accepted by FHA. HUD is very conservative in the way it views the world. Even if a project is well supported from our perspective, HUD might consider it risky,” says Minchey. “For some, the benefits outweigh these disadvantages. By and large the bigger companies used to find it easier to just go with bank financing,” adds Minchey. “We are not looking at new construction financing right now. We want to reduce risk real estate exposure. But we are still making loans to someone who we have a good relationship with. We want all of a client’s business—cash management, deposits and anything else we offer. The current situation has forced [lenders] to go back to conservative underwriting standards.” Sources Other than FHAThe biggest competition to FHA financing comes from small community banks in the case of local projects. Since HUD likes to do deals in smaller markets as well, this can happen often. Tim McKay, senior investment advisor in the Oklahoma office of Hendricks & Partners says, “Regional banks in Oklahoma and Tulsa are asking for 60 to 70 percent loan to cost. They are more dependent on the appraiser, which increases the equity terms. Interest rates are a little high. [Interest] rates were in the 6 range, now they are in the 7 range. It’s tough out there but a great opportunity for developers who have the vision and get it done.”According to McKay, persistence and long-term relationships will help in getting the deals done. “A good track record and history with a bank are factors that help in getting financing.” Local and regional banks will not go outside their regions to make construction loans in the current environment because just making a construction loan does not make sense to them anymore, McKay explains.What Kind of Project is Likely to Get an FHA Loan?“All other things being equal, the emphasis is on green projects,” says Priscilla Lim Harrell, vice president and FHA deputy chief underwriter with Walker & Dunlop. “A project won’t get financing just because it’s green but it will certainly be looked at favorably. Urban renewal projects are also popular.” In 2008, Column Guaranteed merged with Walker & Dunlop and now the latter expects to do over $500 million in new construction loans in 2009 through FHA financing. Meanwhile, the question of when conventional financing will return lingers on. Mark Humphreys calls it the $64 trillion question. “I think it will be determined by the stock market,” he says. “There is a herd mentality in the lending market, so if some start lending, others will follow suit.” He believes the largest apartment construction boom in the U.S. is not behind us but ahead of us. “It will start in the first quarter of 2011 as the echo boomers (more in number than the baby boomers) will come into the market and the supply of multifamily housing will prove not to be enough,” says Humphreys.

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