Wise Construction Lenders Do Their Own Homework
- May 22, 2019
The continuing rosy outlook for multifamily assets is rooted in ongoing U.S. demographic and economic conditions. The U.S. population is growing, while consumers remain reluctant to purchase homes following the 2008 home ownership crisis and recession. The Millennial generation introduced lasting lifestyle changes that favor rentals, and, at the same time, increasing numbers of baby boomers are downsizing from single-family homes to smaller, more manageable rental units.
Meanwhile, after four rate hikes in 2018 and a promise of more, Federal Reserve Chairman Jerome Powell is leaving interest rates stable, with no increases predicted in the immediate future, thanks to a healthy Q1 2019. Today’s low interest rates favor new investment. Smart investors are choosing to borrow now, and not wait for a potential, even inevitable, future interest rate increase that will create a tougher climate for investors.
Finally, construction of commercial projects is everywhere, at or near all-time highs. Construction costs, however, have risen and continue to rise, due to a significant increase in the costs of materials, labor and land. These costs have an impact on everyone involved with a project, including lenders.
Many fund managers rely on third-party information to make decisions on a construction loan’s basis, especially its cost basis. At Parkview Financial, however, we believe outsourcing the construction management functions that drive a loan basis and subsequent fund disbursements is to outsource the most critical decisions a construction lender can make. Lenders need to do their own research based on in-depth market knowledge to make wise decisions about their correct lending basis.
Therefore, debt funds that remove their own personal oversight from determining their lending basis and instead delegate the responsibility to a hired consultant are exposed to greater risks. Only by applying decades of construction experience to the lending market can an independent lender deliver high returns without proportionally more risk. The knowledge-intensive process of fine-tuning each loan’s cost basis and disbursement schedule internally is irreplaceable, and cannot be effectively reproduced by a third-party consultant. There is no substitute for the knowledge and understanding of an experienced commercial real estate lender in underwriting construction loans and managing them on a monthly basis while the project is underway. Value is realized when a newly completed asset is delivered to a market where participants are willing and able to purchase or lease the product.
Lending decisions must always be paired with a prudent business plan that, when executed, will create a finished product with value far exceeding cost. The lender must conduct a thorough review of the project drawings and budget and seek to fully understand all of the development’s metrics. Each borrower comes with a unique set of demands, procedures and goals. Lenders that conduct due diligence, including a site visit, are giving each project the time and respect it deserves.
It is crucial for the lender to understand the market indicators that affect the demand for multifamily products—including the ones touched on above—in depth and in detail. For inexperienced lenders who outsource to consultants, the discontinuity of market pricing information, coupled with lack of knowledge of the components of the construction loan’s basis, results in debt funds disbursing construction funds at the wrong basis, and doing so repeatedly without realizing it. This happens to lenders who fund loans and make disbursements unaware that the loan and disbursements are at a too-high basis. Trouble can arise when a loan comes due with the project unfinished. If no willing buyer will purchase the unfinished project, the lender has to take it back.
Fund managers who make loans and fund construction disbursements at the right basis will not only be in position to navigate the rough seas of a potential market correction, but will also own excellent assets at a significant discount.
Paul Rahimian is chief executive officer of Parkview Financial, a private construction lender based in Los Angeles, CA.