Since the onset of the COVID-19 pandemic, construction lenders have been cautious in selecting the development projects they pursue. While construction financing is not without challenges, with the right sponsor and vision, projects are being capitalized and financed.
Early in the pandemic, many construction lenders hit the pause button to evaluate the situation, run stress tests on their existing loans and shift commercial real estate staff to facilitate COVID-related relief loans. They eventually returned to construction lending, albeit at generally lower loan-to-cost, or LTC, levels; wider all-in coupons; and with more stringent recourse guarantees.
Now, lenders are selecting construction deals with repeat borrowers developing build-to-suit, preleased industrial assets and multihousing projects in the New York City and Gold Coast — Hoboken and Jersey City — markets, as lenders mitigated risk in making those loans. Having an existing depository relationship also helps.
Regionally, we see a softening in the economics and performance of New York City and Gold Coast assets tied specifically to COVID-19 residential occupier trends, including the short-term desires of residential tenants for more green space and less-expensive rent in the suburbs.
The lending market is not naïve to this recent phenomenon; however, many in the space have underwritten through any additional implied risk by lowering their LTC basis and requiring additional recourse. Additionally, the appetite for multihousing projects in New York City, Hoboken and Jersey City has recovered stronger than anticipated, as many lenders take comfort in recent positive vaccine news and the ability to deliver product three or more years from now.
This reduction in senior leverage has forced developers to invest more capital into the project during the construction stage or has opened the door for subordinate debt to fill the capital stack from approximately 55-70% LTC up to 80-85% LTC, with a more expensive preferred equity or mezzanine loan to capitalize the project.
Subordinate debt typically is priced in the low-to-mid double digits range and can be structured as a current-pay or accrual, depending on the senior lenders’ willingness to have a subordinate loan paid during the construction period. If the loan is accrual-based, it becomes payable once the property generates cash flow to pay both senior and subordinate lenders.
The result is twofold: a higher blended cost of capital to complete the project and a larger total project cost. As the investment sales market, specific to multihousing and industrial, has improved through the COVID-19 pandemic, we see two things materialize: 1. The appetite from the subordinate lending community has increased; and 2. Borrowers have recognized the inherent value of borrowing some higher-yielding subordinate debt in the interim if they can hold onto the majority of the equity in the transaction and capitalize the upside via an aggressive permanent refinance with a GSEs, conduit, insurance company or bank lender. With strong macroeconomic tailwinds in the industrial and multihousing sectors, both lenders and borrowers are finding comfort in these changing structures.
If a borrower is willing to be flexible on the capital structure, there is still extremely strong interest in the senior and mezzanine debt markets to get projects off the ground. At the end of the day, value is generated and realized at project completion and lease-up stabilization. If a borrower is willing to take on additional incremental structure and higher cost of capital, a deal will find a home and get to the finish line.
Thomas Didio is a senior managing director with JLL Capital Markets.