The Capital Stack - Part I - Construction Loans

And why you should typically go local!

Alright, Bright Builders. We’re talking about your “capital stack” and, more specifically, the “whats” and “hows” of construction loans.

The capital stack refers to how you're going to layer the capital to do your projects. The most common way to fund your project is with equity (from investors) and then construction financing.

However…

It's important not to go out shopping for equity for your multi-family development until you have a sense of what your construction loan will look like. If you don't know what your loan looks like, you don't know how much equity you'll need. You might have a rough idea and can certainly have some conversations, but never put out an equity offering memorandum beforehand.

Okay, I’m going to get in trouble for saying “never,” but it’s unwise to start raising equity or putting out an equity book until you know your loan. You're going to look silly if you go out looking for five million dollars and then have to call people back and ask for six.

When it comes to investors, confidence is inspired through consistency.

So, first, we button down our loan, and THEN we go out searching for equity.

When it comes to construction financing for new multi-family developments, there are typically four avenues: local banks, national lenders, CMBS loans (Commercial Mortgage Back Securities), and HUD loans.

I typically use local banks. And here’s why:

If they've already financed multiple developments in your market, they know your market and its players. You don't have to pitch them on the market. They know the risks. They know what has been working and why.

National lenders can sometimes offer better terms than local groups, but they always have strings attached. And they're always risky. The biggest reason to go with a local bank is that if something goes wrong, you have a relationship with that bank, with that mortgage lender, with that person.

If something goes wrong with one of my projects, I have my lender’s cellphone number. I'll call and have a conversation with them.

In late 2008, when the great financial crisis happened, and the #$@% hit the fan nationally, all lending dried up. We were smack dab in the middle of building a condo building in the Bay Area and needed to restructure our loan. But when I picked up the phone, I found out that EVERY… SINGLE.. PERSON.. on the lending team we had worked with to put the deal together had been let go.

Yup.

I spent over a month dialing Bank of America’s 1-800 number daily, just trying to get in touch with someone to discuss our project. Contrast this with picking up your phone and calling your local lender, who you see maybe once a month at your favorite coffee shop or your kid’s school.

Does your lender need to be George Bailey from It’s A Wonderful Life? No, but you need access. And proximity.

Your capital stack starts with a construction loan from a local lender.

How do you get lenders interested? We typically put together an offering book of 15-20 pages, including the business plan, some renderings, our pro forma, and operating budget. (You’ve been doing your research, right? You’ve been studying who has loaned on what projects in your market and have reached out to them to start a relationship, so when the time comes to shop for a loan, you have relationships, right?)

We send this book out to lenders, and they'll turn around what's called a “term sheet.” The term sheet will outline the major terms of the deal. What's the interest rate? Is it fixed or floating? (Fixed meaning it's set, floating meaning it's variable) What's the loan to cost? (What percentage of the total project cost will they loan?) Is it gonna be 70% loan to cost? 80%? That number goes directly to how much equity you'll need and the debt service coverage ratio you need to hit in your operating budget. (Typically 1-1.25) We want to know if the loan is recourse or non-recourse. If it’s recourse, you're personally guaranteeing it. Most, if not all, construction loans from local banks will be full recourse. We also want to know the terms of the loan. Is it a three-year construction term? Is it a five-year? One of the best lessons I learned is always to make sure you can extend loans on the construction side.

One of the biggest ways to get in trouble in real estate is having to pay off a loan when the market is not ready for you to pay off that loan.

We typically do five-year loans. We push for three years of interest only and then two years of principal. We hope to be able to refinance the deals before the interest-only term is over. Sometimes, we can't, and that's where that extension comes in.

The crucial thing is that your capital stack has to match your business plan.

For example, if you're planning to build and sell a project, you won't take out a long-term fixed-rate loan with a prepayment penalty. You'll want the cheapest money for the shortest amount of time.

If you're going to build and hold, you have more options, and a long-term fixed rate is your safest loan. Having said that, you typically can’t refinance that in the short term, and if you've created a bunch of value on a development, which is the hope, you have no way to get at that equity to distribute to investors.

So, nine times out of ten, we aim for a five-year, floating-rate construction loan at the highest loan-to-cost possible. We'll take out that loan, and build our project, and then when we're finished and it's stabilized, we refinance. Stabilization (when it comes to loans) typically means the building is 90% occupied for three months or more. If you've done it right and the timing has worked out, you've built a building that's worth more than you built it for.

And that is magic :-)

Next week we’re going to talk about the second part of the capital stack - equity!