Construction Loans - A Guide for Developers

VIVRE LA DIFFERENCE

A loan is a borrowing of money – the total amount borrowed is called the loan principal - by a borrower from a lender for a specific period – called the loan term. In return, the borrower pays the lender interest based on the loan principal and calculated at an agreed annual rate. The borrower repays the loan either at the end of the loan period – called the maturity of the loan - in a lump-sum – called a balloon payment or bullet payment – or, where the loan is an amortising loan, in instalments during the loan term. This is how a commercial loan is structured.

The pattern and style of a construction loan is different from that of a standard commercial loan. A construction loan is a loan made to finance the cost of erecting or constructing a building or other real estate asset. It can be used to fund ground-up construction, as well as to serve as a bridge loan used to finance the building of improvements at an existing property. The construction loan is a kind of asset-backed security, where the asset exists in the future, in someone’s mind, or in an architect’s drawing.

In a commercial lending arrangement, there are two participants - lender and borrower. A construction project has many more participants than just two. They are the project developer who sponsors the project, the builder who carries out the construction work, the lender who funds the construction, and the letting agent or sales agent who markets the project after completion.

The construction of property is sponsored by a property developer. The property developer is the borrower in the construction loan. The construction lender is a lending bank or other loan investor. Where construction is carried out on leased land, the landowner may also be involved in the financial arrangements. Finally, a second bank, lender or investor, called a take-out financier, makes a permanent loan after the project has been completed.

In a commercial loan, the loan principal remains unchanged during the loan term, except where the loan provides for periodic repayment of principal by way of amortization, or where the loan principal is prepaid - that is, repaid early, before maturity - by the borrower. But a construction loan has a principal amount that fluctuates, usually upwards, depending on the stage of construction of the project.

The principal amount of a construction is not paid over to the developer in a lumpsum at the start of building operations. It is disbursed to the developer according to a draw schedule. The lender permits loan draws to be made, but the draws depend on project progress. The lender monitors construction progress through on-site inspections which are then coordinated with cash advances or draws under the construction loan.

Unlike many commercial loans which are long-term and remain in place for up to several decades, a construction loan is a short-term loan. Its term is based on an estimate or expectation of how long it will take to complete the construction project. This may be months or several years.

For a lender, a construction loan is riskier than other types of property-based lending. The reason for this risk profile is that the economic feasibility of a construction project is hard to assess before construction has commenced. And for a lender, construction projects concentrate credit risk (the risk that a loan will not be repaid) in a small number of developers who borrow large amounts. This is different to residential mortgage lending where the lender’s risk is spread out over a portfolio consisting of a large number of residential mortgage loans made to homeowners who each borrow a small amount.

There are a series of risks that are construction-related or are linked to construction finance. Most projects are completed on time and on budget. But it is hard to estimate the value of a project that will only be completed in two years time or later. Supply and demand conditions over that time scale are difficult to predict.

A two-year time horizon is often used to assess the market.

The construction loan advisor tries to predict how the market will look over that period. What will be the vacancy rate be in two years’ time; what will supply in demand look like in the market at that point?

Before the construction loan is granted and construction commences, a pro forma cash flow forecast for the completed project is prepared. This forecast predicts how the property is expected to perform after it has been stabilised. But by the nature of construction lending, before completion of construction, actual cash flow and cash flow forecasts will be volatile and uncertain, and risky for all participants in the project.

CONSTRUCTION, AND CONSTRUCTION-RELATED

Loans that are made specifically to fund the direct cost of construction are easily identifiable as construction loans. But a construction project is a complex process, and it goes through a series of phases or stages.

Construction-related loans are made in other phases of the project.

Construction loans and construction- related loans fall into three categories:

A standard construction loan is a loan for a fixed amount that is granted to fund the cost of constructing a building or similar property asset. The parties intend that the loan will be repaid with takeout financing, which will have been pre-committed to repay the construction loan as soon as construction is completed.

An extendible construction loan is a construction loan that is granted for an initial term, but which has conditions that give the developer an option to extend the loan term, either when the project has achieved specific milestones, or at the discretion of the lender.

A permanent property loan is a loan that is used to repay a construction loan, once construction has been completed, and the property has become stabilised and is generating income satisfactorily.

VALUATION

The principal amount of a construction loan is directly linked to or based on the value of the construction project and the property that is being built. But the value of the underlying property asset fluctuates as the project progresses. This means that the project must be valued or revalued at several stages during the construction process.

A construction project has four stages of value measurement: unimproved land value; project in progress value, project as completed value, and project as stabilised value.

At the start of the construction project, the amount of the construction loan may be based solely on the value of the land. During the construction phase, the loan amount increases in tandem with the project progress. In the prestabilisation phase, when construction has been completed, but the completed property is not yet generating income, project value is the potential of the property to generate cash. In the stabilised phase of the completed project, the property is valued based on its current ability to generate cash in the future, by renting out space in the property in return for rental income, or by sale of the property or units of the property.

The value of a completed construction project is calculated by estimating the net cash flow that the project is predicted to generate over the remaining term of a construction-related loan, and to determine the present value of that cash flow by applying a capitalization or discount rate that is sustainable.

Net cash flow from the project is taken to include rental generated by leases in place, plus rental generated by additional leases that are signed up until the time that the property is regarded as stabilised, so that there is an acceptably low level of vacancy and the assumed rentals are market-related. Expenses and capital expenditure are fixed at market levels, and are deducted from gross income to determine net cash flow. Some property- related expenses are deducted from the stabilised value of the property. These expenses include rent losses, the cost of tenant improvements, leasing commissions, and free rent.

ASSEMBLING THE CONSTRUCTION LOAN

A typical scenario for the assembly of a construction loan starts with a developer finding land that it believes is suitable for the construction of an office building. The developer does not buy the land, because it does not have finance of its own to make the purchase. The developer has an outline design for an office building, and has done research into the level of supply and demand for office space in the project location. The project has no preconstruction lease commitments. The developer commissions an architect to draw up detailed plans for the project. The developer obtains a valuation of the proposed project based on the architect’s plans. The developer funds this preliminary work with an unsecured corporate loan from a bank, that it has obtained specifically for this purpose. This loan may eventually convert into a construction loan.

The developer approaches the construction lender, which may be the same bank that made the corporate loan, or it may be another bank, or some other investor. The developer asks to borrow funds to develop the office building. The prospective lender reviews the developer’s project valuation and based on that valuation, the lender gives a loan commitment to the developer. The loan commitment states that the lender will make a construction loan to the developer, and that the loan will be funded – paid out to the developer - over the construction period. The interest rate on the loan will be a floating interest rate based on an index such as LIBOR, and it may have a floor or minimum rate built in and designed to ensure that the lender will earn a minimum spread over its own cost of funds. The developer pays the lender a commitment fee for making the loan commitment. The developer also pays a loan origination fee to the lender to cover the lender’s costs of making the loan – preparing the loan documentation, and servicing the loan.

Because the loan has a floating interest rate, the lender offers the developer the option of buying an interest rate cap – a derivative contract that sets a ceiling on the interest rate that the lender will have to pay over the period of the construction loan. The cap will protect the developer from the effects of any increase in interest rates during this period. Because a cap is contracted for a 12-month period, the developer will have to renew it on each anniversary of the contracting of the construction loan.

The developer does not have its own funds available to pay the loan commitment fee and the interest rate cap fee. So the lender makes an unsecured corporate loan to the developer, which the developer then uses to pay the fees. The developer uses the first draw on the construction loan to repay the corporate loan, thereby effectively converting the corporate loan into portion of the construction loan.

A construction loan can be for an amount of up to 100 percent of the value of the completed project. If the project is sold for its appraised value after completion, and the construction loan has been repaid, the cash proceeds of the sale may have to cover interest and loan fees that were debited by the lender during the construction phase.

A construction loan is risky for the lender. To control this risk, the lender has a choice. It can play the part of an arm’s length financier and accept the associated credit risk and other risks that a construction loan entails. Or it can try to reduce these risks by playing a closer role in the project, by taking an equity interest or quasiequity interest in the project. A lender that has acquired an interest in the residual profits of a project is said to have received an “equity kicker”.

The lender’s equity interest in the project can be structured in several ways.

The lender may be given the right to receive a specific percentage of profits from the sale or rental of the completed project. This would clearly count as an equity interest in the project.

Or the lender may be entitled to receive loan interest at a rate that is higher than the market interest rate, or loan fees that are higher than the fees customarily charged in the market. The lender would then have an equity interest in the profits of the project, although designed in a more subtle way, giving the lender a return similar to that of an equity interest.

Or the lender could finance all loan fees and construction loan interest itself, expecting to be repaid out of the proceeds of the property or the cash flows generated by it.

For the developer, lender equity participation would mean that, although the developer might hold title to the project, it would bear little or no risk of project failure, because it has no capital invested in the deal.

Where the lender takes an equity interest in the project, the financing transaction structure could be different to that of a standard construction loan. One of the following structures could be used.

The lender could purchase the land in its own name. Interest on the construction loan would accrue monthly, and the interest rate would be adjusted whenever market rates fluctuate. But the developer would not be required to make any loan payments until the project had been completed, so that interest that accrued during the construction period would be added to the loan principal. The developer would complete the project, and receive a developer’s fee equal to a percentage of the construction loan principal. The developer’s fee would be funded through the construction loan. The developer would also receives any profit that might be left over after the lender’s equity interest in the project had been paid out.

Or a land warehousing structure could be used. The developer would earmark land for construction. The lender would then purchase and takes title to land, and grant an option to the developer to purchase the land. The option price would be greater than the cost of the land to the lender.

The lender would hold the land until the developer was ready to use it, at which time the developer would exercises the option and acquire the land from the lender. The gain realised by the lender from acquiring the land and reselling it to the developer would be treated by the lender as a capital gain. The developer’s payment would be financed out of the construction loan, and would be recouped by the developer when the property became cash flow generating. Giving the lender an equity interest in the loan can change the character of the transaction from construction loan to joint venture or partnership between developer and lender, or into an investment by the lender in the developer.

As to whether the transaction character has changed, the questions are - How much risk is the lender taking? Does it have an interest in the project’s profits? Will it earn an amount over and above arm’s length interest and loan fees that a construction lender normally earns?

If the lender acquires an equity interest in the project, it can be exposed to liability for project defects. Construction lenders are not usually liable for defects in the projects that they finance, but a lender who is a partner, joint venturer or investor could become liable, possibly jointly with the developer.

THE CONSTRUCTION LENDER’S ROLE

A lender involved in a construction project gets three lending opportunities: to make the land loan, to make the construction loan, and to make the permanent loan. The lender may also fund project operating deficits for short periods. Where completed project units are sold to end-user purchasers, the lender may ask for a right of first refusal to finance the purchases to be made by those purchasers.

In its role as construction lender, the lender may ask for information regarding the project: the names of sub-contractors, descriptions of the work that they will do on the project, proposed selling prices of completed units in the project, and details of lease negotiations and signings of prospective tenants. The lender may review plans, specifications and cost breakdowns for the project. The lender may have its own team of property inspectors who will visit the project on a regular basis to protect the lender’s interest in the project, to ensure that construction is proceeding to plan, and that loan funds are disbursed only for completed work.

Where the lender has a substantial equity interest in the project, this could give it effective control of the project. If the lender is the only party at risk in the project, or the main party at risk, then only the lender stands to gain from the success of the project up until the time when the developer repays the construction loan. To protect its stake in the project, the lender controls disbursement of the construction loan, and the progress and direction of the project.

Because the developer cannot receive any return until the project has been completed and starts to generate cash, the developer has an incentive to complete the project as quickly as possible. During the construction phase, the developer has nothing at stake, and only becomes interested in the project when it has been completed and starts to operate successfully. The lender must then control the project to ensure that the developer does not give in the temptation to cut corners in building operations. This is specially important where the developer, or a project special purpose vehicle, is thinly capitalised and dependent on construction loan financing. This increases the risk of defective construction. So the lender monitors construction operations, looking for errors in workmanship and design. The lender can demand to review plans, inspect construction, approve construction methods, and supervise builders.<.p>

The construction lender has two overriding risks – financial risk – the risk that the project will not be completed on budget, and timing risk - the risk that the project will not be completed on time.

Although financial risk is the main risk, construction projects often deviate from plan. Construction budgets change and overruns are common. But as long as deviation from original budget is not too severe, the project participants usually accept that the construction loan remains balanced. Provided that the property market has not changed dramatically, the lender can assume that it will eventually end up with a mortgage over a completed property.

Timing risk can be reduced by a having a carry reserve attached to the construction loan.

In the pre-stabilisation phase, the lender may also participate in negotiation of leases.

KEEPING THE CONSTRUCTION LOAN BALANCED

A construction loan is said to be “balanced” when the remaining available funds from all sources add up to a total amount this is big enough to fund the project through to completion. The funding sources are the proceeds of the construction loan, any contingency reserves, and borrower equity.

A construction loan can run into unforeseen problems, such as strikes, natural disasters, and unexpected increases in the costs of materials and labour. These events can occur even where the loan agreement has been carefully negotiated, and it is not possible to negotiate away every possible negative contingency that might affect the project.

If project cost overruns are caused by unforeseen contingencies, they can be covered either by an equity injection by the developer, or by contingency reserves that are included in the construction budget from commencement of the project. If adjustments are made, the loan becomes balanced again and the project goes ahead.

A construction loan that is well structured and made to a developer that is experienced, motivated and financially robust is unlikely to become unbalanced.

But imbalances can still occur, and when they do occur they may be hard to cure. The contingency reserve may turn out to be underfunded, or the developer may be unwilling or unable to contribute enough equity to relieve the problem.

The timing of an out of balance event has an effect on the decision how to respond to it. A newlycommenced project has a greater chance of encountering an out-of-balance event, than a loan that is near completion with the majority of its costs already determined and attached to the ground. An out-ofbalance event is most severe in the early stages of the construction phase. It is least severe towards the end of the construction phase, when the project can be completed for only a small additional outlay, and there will be little if any loss incurred on the construction loan.

What can be done if the construction loan becomes unbalanced, and attempts to rebalance it are not successful? In extreme cases, the best course of action may be to liquidate the project, even if it is only part completed. This could be the most practical choice where loan imbalance has been caused by macroeconomic factors. For example, where rental rates, vacancy rates, or interest rates have changed substantially from the rates prevailing at the time the loan was contracted, or from the rates that were predicted at the commencement of the project. Or where the cost of construction inputs - materials or labour - have markedly increased.

Where the loan becomes unbalanced but the construction lender is an institution, it is likely to complete the project with its own funds, because this may be the best way and perhaps the only way in which it can maximise its recovery on the part-completed project.

When there is an out of balance event and the lender does complete the construction, it adds the additional cost to the amount of the construction loan principal, as the property enters the pre-stabilisation phase.

THE CONSTRUCTION LENDER’S RISKS

A construction lender assumes a number of risks: Construction risk - the risk that the project will not be completed on time or on budget. Carry risk - the risk that during the construction period and the pre-stabilisation period there will not be enough cash flow available to pay interest on the construction loan. Take-out risk - the risk that there will not be enough funds available to repay the construction loan when the project has been completed.

Also, the identity of the parties who are involved in the project will affect the project risk. The construction lender focuses on two parties who are critical to the success of the project – the developer and the letting agent. The lender asks what is the developer’s previous experience with construction projects. A developer with significant financial strength has the ability to maintain the construction loan if it becomes unbalanced, or to come up with additional funds needed to complete the project.

The lender’s risks can be mitigated, in the following ways.

Firstly, by the developer making an equity investment in the project. The investment can be in the form of cash or a contribution of the land on which the project is to be built. Now the lender is not financing the entire project on its own. The developer has some equity at risk, and will have an incentive to protect its investment, and if it does, it simultaneously protects the lender’s interest.

Secondly, by the developer giving collateral. This collateral can be in the form of substantial, saleable assets with a determinable sale value, that are owned by the developer. These assets should not already have been pledged as security for some other loan, in other words, they should not be encumbered in any way. Alternatively, the developer can give an irrevocable letter of credit from a financially robust loan guarantor, that covers a substantial part of the construction loan over its entire term. If the developer gives collateral, the implication is that the developer has something substantial to lose, as well as a strong incentive to make the project succeed. For the lender, a letter of credit is the best type of collateral, because it covers interest, fees and loan principal for the full loan term.

Thirdly, by a creditworthy outside financier giving a take-out commitment for the full amount of the construction loan. The commitment should be unconditional. If there are conditions, they should be reasonable. If the take-out commitment will “cash out” the lender for the amount of the construction loan on completion of the project, then the outside financier – rather than the construction lender - has the risk of economic failure of the project. Now the construction lender’s only risk is that that the project will not be completed on schedule. If there is a take-out commitment, then project value is no longer an issue for the construction lender, because an outsider has agreed to effectively repay the construction loan, including all of its interest and fees, once the project has been satisfactorily completed.

Fourthly, by arranging some other type of implied guarantee of the project’s success. This guarantee can be in the form of sale agreements or lease agreements entered into with creditworthy independent outside investors or lessees. Arrangements like these will substantially reduce the construction lender’s risk. They will generate the cash flow on completion of the project that will be needed to repay principal and interest on the loan.

CONTROLLING CONSTRUCTION RISK

Construction risk is correlated with the percentage completion which a building project has attained. A project that is close to completion has less construction risk than a project that has just been commenced. A completed building project has no construction risk.

Construction risk can be reduced, in the following ways.

Firstly, by the developer putting up project equity of its own. The developer contributes its own capital or assets to the project, in the form of cash or land.

Secondly, by structuring the construction contract as a fixed-price contract. With a fixed-price contract, the developer or builder agrees to construct the project for a price that is firmly fixed before construction begins. But for this undertaking to have value in reducing risk, the builder or developer must be reputable, experienced and creditworthy.

Thirdly, by using a system of retentions. Instead of paying the full construction loan principal to the developer or builder when construction starts, the lender pays the developer or builder in stages and holds back some part of the loan. Payments are made when specific project milestones are achieved. For example, a loan for the construction of a multi-storey office development is disbursed to the developer or builder as and when specific number of floors of the building have been completed. This enables the lender to monitor the project and to reduce its risk by keeping back part of the loan and taking a wait-and-see approach to the project.

Fourthly, by providing for budget contingencies. If the project budget has an overrun cushion built into it, then that is a surplus that can be used if construction costs turn out to be greater than predicted. How much of a cushion is needed depends on how complex the project is, and how long it will take to complete. Budget overruns are usually about 5 percent to 10 percent of the amount budgeted for the project.

Fifthly, by arranging guarantees. Construction project guarantees come in three forms, all of them surety bonds – performance bonds, payment bonds, and completion bonds.

Performance bonds are guarantees that protect the construction lender if the contractor, developer or builder fail to complete the project. The surety is then obliged to take over the project and complete it, or to make a payment to the lender or developer that can be used to hire a new builder to complete the project. The performance bond penalty should be the full amount of the cost of construction.

Performance bonds are critical in reducing constructionrelated default on a construction loan. Construction loan losses then depend on the type of performance bond, the penalty that it imposes, the conditions under which it is payable, and the identity of the issuer of the bond. If the surety who issued the bond is financially strong and is obliged by the bond to complete the project, then potential losses on the construction loan during the construction period will be minimised.

Performance bonds usually only require the surety to perform if the original contractor was obliged to perform, and then to the same extent as the original contractor. So if the original contractor is not liable to perform, then neither is the surety. This means that performance bonds are often hard to enforce. Also, not all construction-related problems are covered by performance bonds. Natural disasters, undisclosed or unknown conditions, such as land subsidence, are not covered.

Payment bonds are guarantees given by a surety who guarantees that all third party suppliers of labour or materials to the project will be paid.

Completion bonds are guarantees that a part-completed construction project will be completed, regardless of cost.

CONTROLLING TAKE-OUT RISK

Take-out risk is the risk that the balloon payment or bullet payment due to be made by the developer to the construction lender on the loan at maturity will not be able to be made.

This risk is introduced or increased because of increases in interest rates, or because the property fails to perform as expected.

After construction has been completed, the probability of take-out financing failing may depend on what type of take-out financing has been arranged. Or it may depend on the economics of the completed project.

What will the property market be like when the project is completed? Will it be tight with property shortages, or will there be a surplus of property driving down the value of the project on completion? These factors all have a bearing on take-out risk.

CONTROLLING PROPERTY RISK

After construction has been completed, constructionrelated property risk still remains, because the value of the project might not be enough to repay the construction loan. The project may be worth less on completion than was projected when the loan was made. Or the value of the property may be less than the amount owing on the construction loan.

Property risk is reduced if an investment grade tenant leases a substantial portion of the property, for a long period.

CONTROLLING CARRY RISK

The construction project must be able to generate enough cash from operations or from other sources to pay interest and principal on the loan, through all of the project phases. The payment of amounts due under the construction loan is called loan servicing. Loan servicing may involve the payment of interest only, or both interest and principal where the construction loan is designed to amortise during the construction and stabilisation phases. The risk that the project will not be able to generate enough cash to service the loan is called carry risk.

It is important for the lender to ensure that carry risk is reduced or eliminated. The project must be able to meet its debt service obligations, from the time that the construction loan is contracted up to the time that the property is leased to the point at which it can be said that the property has become stabilised.

During the construction phase and the prestabilisation leasing phase, a debt service carry reserve is used to ensure loan servicing. The role of the carry reserve is to cover cash flow shortfalls. The carry reserve is established and maintained so that it contains enough funds to cover construction loan interest. The reserve is then used to service the construction loan until the project reaches stabilisation, or at least until the cash flows that the project generates are able to satisfy the requirements of debt servicing. It ensures that interest on the construction loan is paid on time. The reserve is needed if at this time the property is not generating enough cash to service the construction loan, that is, to pay interest on the loan. The carry reserve provides for the servicing of the loan from the construction period through the pre-stabilisation phase before the property is leased up to break-even point.

How big should the carry reserve be? Big enough to ensure that interest on the construction loan is paid on time, during the period in which the property is not generating enough cash flow to service the debt. A major complex construction project will have a big carry reserve buffer, a small project will have a minor reserve or some other form of provision for loan service.

The carry reserve is part of the construction budget. The existence and size of a carry reserve are important factors relating to credit risk in the construction loan. The size of the carry reserve will determine whether the loan needs other forms of credit enhancement. The bigger the carry reserve, the lower the chance of default on the construction loan, and the lower any loss that might be incurred on default will be. The reserve must be big enough to cover interest payments, as well as property tax and insurance, during the construction period and the prestabilisation leasing period.

The reserve can also take the form of an insurance policy or a letter of credit that covers all payments due under the construction loan, until the project has achieved a debt service coverage ratio of 1:0. That is, until there is enough free cash flow being generated by the completed project to cover all payments that are due under the construction loan.

OTHER RESERVES

The ability of the project to generate enough cash to meet operating costs should be monitored. It should be able to cover these costs from the date on which the loan is originated by the lender, to the date on which the entire loan principal is repaid. The construction loan structure may have a modest buffer period built in, usually enough for several months. Reserve are maintained to cover fixed operating costs, for example, property taxes, insurance, and security expenses. A delay cost reserve will cover expenses that might be incurred because completion or stabilisation of the project has not been completed on time.

For example, payments to compensate a key tenant that has leased space in the completed project but is unable to take possession of the leased premised, because the project has not yet been completed.

Or a penalty that is payable to an anchor tenant, such as a supermarket chain, for late opening of a retail centre.

PRE-SALE AND PRE-LEASING

Pre-leasing can mitigate the credit risk of a construction loan. A large amount of preleasing to creditworthy tenants will reduce cash flow volatility. Pre-leasing depends on supply and demand in the property market, and on the amount of speculative construction that is taking place in the market.

But even a property that is fully pre-leased to an investment grade tenant is not absolutely guaranteed to perform. The tenant may go bankrupt in the interim, and because a lease is an executory contract, the tenant’s administrator may reject the lease and walk away from the project.

Pre-leasing can reduce carry risk. If all or part of the property is pre-leased to a tenant, the tenant may make payments to the developer that are sufficient to cover the construction debt servicing costs. A high percentage of pre-leased space also reduces property risk.

The amount of space that is pre-leased varies from project to project. The more space that is pre-leased, the less exposure there is to the real estate market in the future. So the more preleasing, the lower the credit risk of the construction loan.

The extent and quality of pre-leasing can be important with respect to establishing the final maturity date of the construction loan.

The loan agreement may give the developer the right to extend the maturity date, provided that the property meets predetermined performance standards.

The parties may even agree that the construction loan will not be made until a specified number of units of the proposed property have been presold or pre-leased prior to the commencement of construction.

STABILISING THE COMPLETED PROJECT

Once construction of the property has been completed, the project goes into a phase of financial and operating stabilisation. But before stabilisation is achieved, the property experiences a period of prestabilisation. During this period, there is uncertainty about how the property will perform.

The expected performance of any newly-constructed property is uncertain. An existing property has an established tenant clientele and several years of historical performance statistics. But a new building has only pro forma accounts drawn up by the developer, valuations, and market data, on which to base a view on how the property will perform. Uncertainty about how the property will perform is increased, depending on the type of property and the time that it will take to get the property fully stabilised after completion. The volatility of net cash flow is also greater if it is unknown how the property will perform when it has been completed, how much rental income it will generate and what expenses will be incurred in maintaining it.

A loan that is secured by a newly-built property that has not yet been stabilised has a greater probability of default and a greater loss given default and loss severity, than a loan secured by stabilised property. The implication of this is that at this time the developer is more likely to default on the loan, and the lender is likely to incur larger losses if default does occur. But if the property is pre-leased or constructed units of the property have been pre-sold, the risks are reduced.

Construction loans with extendible terms that run through the pre-stabilisation phase have stabilisation risk. The extent of that risk depends on the net cash flow from the property once it has stabilised and a loanto- value ratio has been worked out.

REPAYING THE CONSTRUCTION LOAN

After the initial valuation of a planned construction project, a lender analyses the project’s net realisable value to determine whether the construction loan is likely to be repaid.

Every construction loan must eventually be repaid. This can effectively be done in three ways – firstly, by using the proceeds from the sale of the completed project to an outsider; secondly, by the developer obtaining permanent financing from another lender; or thirdly, by the construction lender converting the construction loan into a permanent loan.

For the construction loan to be repaid, the project must be successful. If a construction project fails economically, then the loan based on that project will result in a loss for the lender. In a construction loan, the loan principal may cover both the cost of the land on which the project is built as well as the construction costs. The developer pays interest and loan fees out of its own resources. So, for the lender to be repaid in full, the final project value need only be equal to the land cost and the construction cost. If the developer has an investment of its own in the project, the lender should recover the full amount of its loan, even if the project value falls, because this loss in value will be borne by the developer.

But where the construction loan also includes loan interest and fees, and the developer is investing little if any of its own money in the project, repayment risk for the lender increases. For the lender to recover the full amount of its loan, the project must be sold or refinanced for an amount that is at least equal to the land cost, construction cost, interest and loan fees. If the lender has no cushion of safety from the developer’s own investment, any decrease in the value of the project will be borne by the lender, not the developer.

A construction loan may be structured on a non-recourse basis, so that the lender is not permitted to call on other resources of the developer for repayment. The lender’s only security is then the project itself, perhaps strengthened by a mortgage over the land on which the project is being developed. Or the loan may be structured to be recourse to the lender, in which case some form of guarantee will be given by the developer, the developer’s holding company, or an outside guarantor.

The value of a loan guarantee is measured by the ability of the guarantor to perform, the practicality of enforcing the guarantee, and the demonstrated intent of the lender to enforce the guarantee. A guarantee of a construction loan only has value for the lender if the guarantor’s ability to meet the guarantee can be reliably assessed, and the amount of the guarantee covers a substantial part of the loan.

DEFAULT—THEN WHAT?

If the borrower in a construction loan defaults, the lender will incur a loss. The amount of the loss that will be incurred by the lender will depend firstly, on any shortfall in project value, and secondly, on cost overruns that are incurred in completing the project.

If there is default under the construction loan, the lender has a number of alternative ways to retrieve its money.

It can look to portions of the loan not yet paid over to the developer, loan principal that might be held in trust, cost reserves, retentions held back by the lender, a claim against the developer for repayment of the loan assuming that the loan is recourse, and the liquidation or sale value of the uncompleted project.

Lenders know that default losses can be minimised by completing the project. This might involve the lender itself taking over the project, rather than by trying to sell a partly built property.

PERMANENT FINANCING

A construction loan is a short-term loan that meets a specific need – to pay the building costs of a construction project. It is a stop-gap between a land loan and a permanent property loan.

A construction loan comes to an end at the time when the construction is expected to be completed. At that time it is replaced by a permanent property loan.

The permanent loan is a form of long-term financing that is repaid over the useful life of the completed project, which may be years or decades, or some shorter period with the intention of refinancing it at a later date.

The maturity date of a construction loan is set at the date or shortly after the date on which the lender and the developer agree that the completed project it predicted to have become stabilised. The time between construction completion and the maturity date of the loan may be longer for big, complex projects, like major office developments, and shorter for small simple project, like industrial buildings.

Once the project has been completed, the developer obtains permanent financing for the project. This can take the form of a roll-over of the construction loan into a permanent loan. Or it can involve obtaining a new loan from another lender. Or the developer can sell the property once it has been completed, use the proceeds to repay the construction loan, and take any remaining surplus as its profit from the project.

If the construction lender agrees to also make the permanent loan, then another loan commitment is made, and a new loan agreement is entered into. The lender is again paid a commitment fee, and a loan origination fee. Here again, the developer may use a draw on the construction loan to pay this initial cost of obtaining the permanent loan.

The permanent loan can include the lender’s agreement to fund initial project operating deficits, up to a set limit, until the property has been fully leased. This gives the developer the cash that it needs to turn the newly constructed building into a profitable operation.

Once a permanent loan is in place, the owner of the property uses cash flow that is generated by operation of the property to repay that loan. Under the permanent loan, the developer is usually required to make monthly or quarterly payments of principal and interest. Interest on the permanent loan is also usually calculated at a floating rate, which is set at a fixed level above LIBOR, usually between a floor and an optional ceiling.

The interest rate that is payable on the permanent loan is usually lower than the rate payable on the construction loan, because the risk to a lender on a newly completed building is less than the risk on a building that is under construction.

Not every construction loans is made with the intention that it will be replaced by permanent financing as soon as construction has been completed. Some construction loans have their terms extended and they continue through the stabilisation phase of the property, and are only replaced after the property has been leased and is generating a stable cash flow.