Construction Lending Returns to Core Markets

The worst in the cycle is behind us. Vacancy rates and absorption numbers show signs of improvement, and rents appear to be stabilizing across most property types.

The worst in the cycle is behind us. Vacancy rates and absorption numbers show signs of improvement, and rents appear to be stabilizing across most property types. Employment, another key parameter for construction activity, has been stabilizing as well. In response, construction lending has returned to core markets.

On the job front, the jobs report in February overshot expectations, propelling the Dow Jones Industrial Average to its highest level in almost four years. While unemployment has been undoubtedly stabilizing, another round of state and local job cuts, as well as the announced loss of tens of thousands of financial service sector jobs, may put the brakes on employment gains in 2012.

Irrespective of GDP growth and unemployment figures, the underlying supply-demand fundamentals are improving. Looking at major gateway cities such as New York, we seem to have reached a decisive point in the recovery. The New York City market has been a bellwether for the rest of the nation. Both overseas and national investors, competing for a short supply of office and multifamily properties, are driving down cap rates and pushing asset prices above replacement costs.

In general, and more particular to the NYC market, developers have been extremely conservative in delivering new product to the market, allowing excess supply to be absorbed. Once overbuilt submarkets such as Williamsburg (Brooklyn) and Chelsea (Manhattan) are now experiencing a significant supply shortage of rental and for-sale product. Due to the long lead time to bring new product to the market, the demand will remain strong well into 2013.

Lenders have recognized the supply-demand imbalance and are responding with an increased appetite for construction loans. Capital is readily available for well capitalized and experienced developers, and rent growth and declining vacancy rates have opened the pipeline for development. While most capital sources for ground-up development gravitate toward multifamily, smaller condominium developments in strong markets and hotel developments in major gateway cities attract conventional financing as well. Even large mixed-use projects are back on the drawing board; later this year Related Cos. and Oxford Properties Group will start construction on the first tower of the Hudson Yards project, a 26-acre mixed-use development on Manhattan’s West Side.

Most construction loans require full personal guarantees. Limited or nonrecourse financing is selectively available to strong sponsors or projects with institutional equity partners. Rates range from the mid-3’s to the high-6’s depending on location, leverage and the financial strength of the developer. Most lenders are comfortable providing up to 65 percent financing. Experienced developers and operators can access senior financing up to 75 percent. With preferred or joint-venture equity, a developer can finance in excess of 95 percent of the capital stack.

The overall expectation for 2012 is that institutions will gain more confidence in the economic recovery and will continue taking on more risk. Institutions have plenty of capital to spend for both core markets and value-add opportunities. A low-yield environment and the need to generate profits will draw more debt and equity sources to development opportunities.

Daniel Hilpert is the managing director of Mortgage Equicap LLC, a New York-based real estate investment banking intermediary.