Hunting Down Alternative Sources of Development Financing
- May 10, 2011
The reality is that capital may still act as a constraint on the volume of new construction that will be possible in the next development boom. At this point, equity financing appears abundant, but it is available generally only for the top projects. Therefore, developers facing difficulties obtaining equity will have to be resourceful in seeking out money among friends, family and other sources. Similarly, banks appear to be providing capital only to the top developers and projects nowadays. Nevertheless, debt financing may be more readily available than equity, thanks to the continued presence of Federal Housing Administration (FHA)-insured financing.
Speakers at an introductory development session, entitled “How to Get Started in Developing Apartments—Financing,” and also at another panel, entitled “Capital Markets Financing Outlook for Apartments and Condominiums,” at the National Association of Home Builders’ (NAHB) International Builders Show this year provided guidance on how to obtain both debt and equity financing for new construction.
According to David Reznick, co-founder and chairman of the Reznick Group, who moderated the NAHB panel, “There is a significant amount of [equity] in the marketplace; however, this equity remains selective. The question is how to get that equity into your pockets.”
Quality projects of sufficient size and desirable, possibly MSA, locations, and if the developer has a strong track record and sound balance sheet, will attract institutional type investors, says Reznick. “For developers or developer groups with good track records, we are seeing a fair amount of activity.”
According to Reznick, investors are seeking 8 percent to 9 percent in cumulative returns and, when that is achieved, up to 12 percent carried interest. Developers are also asked to maintain 10 percent skin in the game—assuming the property is viable and the investor is an institutional, rather than private, investor.
If the project is of institutional quality, there are forums in which institutional-type investors will come to meet with developers, says Reznick. There are also a fair number of high net worth individuals who are seeking to shelter their taxable passive activity income using other rental properties. Such “country club” capital is typically obtained from people the developer already knows. The projects are not necessarily in MSAs, and the capital is not institutional.
The structuring of such equity deals can be individualized and customized according to the requirements of the developer and investor, providing typically 8 percent or 9 percent returns.
Developers can approach the wealth managers of high-net-worth investors. However, even these private groups may not be interested in apartment projects with fewer than 100 units, says Reznick. “We may know certain [wealth managers], but I encourage you to look within your community if your property is up to 100 units, because most of these groups do not want to invest in smaller properties … It may be difficult to get a family group to invest in 85 units in Alabama.”
As the economy improves, it is generally expected that equity sources will be more willing to venture outside the box.
As far as debt financing, one of the biggest sources of debt financing for new market-rate developments is the U.S. Department of Housing and Urban Development (HUD)’s FHA 221(d)(4) new construction and substantial rehabilitation mortgage insurance program. Under this program, developers can obtain 40-year, non-recourse, fixed-rate construction-permanent rollover mortgages at 4.25 percent to 5.25 percent interest, plus mortgage insurance premium. The maximum Loan to Value is now 83.3 percent.
HUD’s FHA program was practically the only financing available for new multifamily construction during the depths of the recent recession. Financing volume under the program has now increased dramatically. Margaret Allen, CEO and owner of FHA Multifamily Accelerated Processing (MAP) lender AGM Financial Services Inc., reports FHA initial endorsements (for acquisition, refinance and construction/rehabilitation), which totaled $7.6 billion in 2004, have more than doubled from $5.4 billion in 2009 to $13.83 billion in 2010. There are three times as many refinance and acquisitions as substantial rehabilitation,
As a measure of the degree by which the FHA financing has grown, in the first 60 years of FHA’s life, it accumulated a portfolio of $40 billion. Last year alone, it added $10 billion—a 25 percent increase in just one year—to its portfolio. About 50 percent of the current portfolio consists of market-rate housing.
It may require a specific skill set to develop properties financed by FHA-insured mortgages, however. “Find the best MAP lender you can. Your lender can make or break you,” advises David Leon, of Broad and Cassel. Developers should try to select lenders that have a record of experience working with HUD, both at the headquarters and the particular field office that they will be going through, speakers advised.
One of the unique benefits of FHA-insured financing is that the construction loan rolls over into the permanent debt. Allen explains that the developer needs only to complete the project and submit to cost certification before the construction loan is eligible for conversion into a permanent mortgage. Unlike Fannie Mae or Freddie Mac takeout financing, lease-up or stabilization is not required before the permanent loan is funded. In that respect, the FHA financing program can be a more attractive option than converting from a bank construction loan to a Fannie or Freddie permanent loan.
One of the notorious aspects of HUD financing is the length of time it can take to obtain approvals. Borrowers may want to plan on the financing process to take six months, “on the short side,” says Leon. If the lender is not experienced, the financing can take six months to a year. Allen points out that the FHA program now has three times more business—at the same time its staffing levels are being reduced. Nevertheless, “HUD wants to bring field offices up to the same standards” and processing is faster than it used to be, she adds. The HUD staff, although being reduced through attrition, is “honest, smart and bound by regulations,” she notes.
Now that market-rate developers are more ready than ever to return to development, one of the trends with respect to FHA financing may be, unfortunately for them, that HUD is emphasizing affordable housing. Reznick noted that HUD may be seeking to correct what the new Administration may have seen to be a very small percentage of affordable compared to market-rate projects being insured. Affordable housing may be getting to the front of the line. Indeed, Allen points out that 70 percent of the FHA insurance pipeline is market-rate housing. “That worries them,” she agrees.
In any case, as the economy improves, other construction debt financing sources may begin to feel confident in picking up the slack.
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