Avoiding Common Pitfalls Of Commercial Construction Financing

Sponsors of commercial real estate construction projects achieve shovel readiness by having a high quality current business plan, including required permits, detailed cost estimates and appraisals. But a shovel ready project may not be finance ready from the point of view of lenders. “Finance ready” means you have in place what realistically will be required by most lenders to move forward now and successfully finance the project. So project sponsors also need their equity and other lender financing requirements lined up to be seen as finance ready.

Shovel Ready: All permitted, costed and planned

Some real estate developers approach lenders before they have a fully developed plan, which is often too early in the financing process. They may achieve a verbal interest from a lender, but lenders need to see a well complete plan to provide an opinion on their true level of interest in financing it and on what the financing costs may be.

To achieve a “shovel ready” project, requirements and supporting documents are typically outlined in a detailed business plan, including:

• Sources and uses of funds, showing high level sources and cost items
• Sponsor/borrower equity being contributed (often 20% or more) including sunk hard/soft costs to date
• Land: Confirmation it is owned, purchase price and date (or) Signed purchase contract/LOI for the land
• List of any existing debt or other encumbrances on land or other project assets
• Construction pro-forma financials showing detailed costs and calendar timelines of all key stages
• Builder/general contractor CV
• Confirmation the necessary building permits/zoning approvals are in place or timeline if coming soon
• Environmental reports if required
• Current market analysis/feasibility study
• As is and as complete formal project appraisal (MAI or similar)
• 5 year pro-forma revenue and profit projections after project completion
• Exit strategy or long term intention if keeping project

Why some good real estate projects fail — avoiding common pitfalls

Whether trying to source traditional bank funding or seeking debt from private lenders, real estate project sponsors can face many challenges when raising capital. Even active lending institutions can be difficult to deal with and loans hard to close.

Unlike some businesses which can grow organically starting with seed capital, real estate projects often require the complete project to be planned up front. It needs to be both ‘shovel ready’ and ‘finance ready’ before all the capital can be secured. Missing components will often prevent the project from getting off the ground.

Understanding the commercial loan process, anticipating likely maximum loan amounts (underwriting ratios) and funding costs, can give you a big advantage when putting your plan together. Each lender follows their own internal underwriting criteria for different real estate projects which includes ratios such as loan to value, loan to cost, loan to personal net worth, percent liquidity on close and whether the loan is recourse or non-recourse. Typically, the value of the project is supported by a formal third party appraisal which addresses the current market ‘as is’ value and the estimated value on completion.

So where do good projects go wrong? As we said, this is often an all-or-nothing prospect. Everything must be in place or the project will not proceed. Here are some common road blocks to success:

The project fails to achieve ‘shovel ready’ status
Typical issues include failing to secure the land contractually, unresolved permitting/zoning complexities and lack of supporting third party market analysis. Unless you have a clear view with near-term timelines to getting these items resolved, seeking financing is premature.

The project fails to achieve ‘finance ready’ status
Typical issues include sponsors not having enough equity to invest in their own project, insufficient unencumbered collateral available and flawed pro-forma cost and revenue projections which are too high level or overly optimistic. Obtaining a current detailed third party market analysis and financial report is important to support your assumptions. Include as much honest transparent detail in your business plan that you can, and make sure your assumptions supporting your sources and uses of funds and costs are conservative and supported by reasonable evidence. From a lender point of view, they want to ensure you have the capacity to service the debt. On existing properties producing NOI (Net Operating Income) lenders review the debt services coverage ratio (NOI/Annual Debt Service) to ensure the property has the necessary cash flow to cover the loan payments. Ultimately the reasonableness of the financials determines the outcome.

Project is too big for sponsors
Pursuing projects well within the sponsor’s financial means is critical. Some sponsors simply lack sufficient PNW (Personal Net Worth) or liquidity on close to meet lender requirements. Lenders often want to review sponsor PNW even if the loan is non-recourse. It is important to show that appropriate collateral or equity for the project is available, often in the 20% total project cost range or higher. Additionally, sponsors need to have a combined PNW which supports the loan amount, which for some lenders must at least equal the loan amount. Some lenders also require sponsors to have 10% or more of the financed amount in liquidity available on close in case the project later has unexpected requirements for additional funds.

Short timelines
Failing to allow sufficient time to find and secure financing, including the time required to complete lender due diligence, results in otherwise viable projects running out of time and dying on the vine. Allow more than enough time if you can. Bridge loans can cover some immediate needs and close in 3 or 4 weeks, such as for acquiring a multifamily building seeking a quick sale, but you still need to have your remaining financing well underway and lined up.

Lack of sponsor experience
Lenders want sponsors with good track records of success in the industry in which they are seeking capital. If you don’t have extensive experience delivering projects like this, bringing in experienced partners to co-sponsor it can be the difference between success and failure.

Unrealistic sponsor expectations
Sponsors fail to be flexible in their financing and expect total financing costs that are too low, not allowing for the risks that underwriters will see in their project. These risks often involve factors such as region, specific community in which it is located, type of real estate project, market risks and many others identified by underwriters. A sponsor’s “my way only” thinking kills deals, as it is the lenders who ultimately make the rules on the costs of financing. A common mistake among real estate project sponsors is under estimating their total cost of capital. Don’t assume you will receive capital at 4% total cost if your project doesn’t meet the lower risk requirements to secure it. Being realistic will save a lot of time and heartaches. You will have to take some risks, including the possibility lenders may reject your project. This is why you must have a viable and profitable project with the right amount of sponsor equity in it (your “skin in the game”), a detailed business plan and an excellent management team. There are no shortcuts.

Connect with us about your real estate or business financing requirements.