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How do construction lenders view risk? Wharton Emeritus Professor Peter Linneman explains.
BRUCE KIRSCH: So let’s talk a little bit now from the lender’s perspective. When lenders look at a potential construction loan, really what they’re looking at from the beginning is, well, what’s the prospect of my principal being repaid, either through a permanent loan coming in and taking out the construction loan, or if the property’s going to be sold from the net sales proceeds once the property’s stabilized and then transferred to a new owner. Now we always hear talk about these loan to cost thresholds of 50% loan to cost and then also loan to value thresholds. What determines how they get to these numbers of 50%, 60%? And how does that all work?
PETER LINNEMAN: Well, first of all, on the development side, their biggest nightmare is that it doesn’t become a building. That somewhere between when they start funding and when somebody doesn’t pay them, it’s not a building. Because they’re lenders, not builders. They’re not even building operators, much less building creators.
BRUCE KIRSCH: Right.
PETER LINNEMAN: So however ill-suited a lender is to be the owner of an up and existing building, given all the complications we just talked about, they’re triply not suited to be a developer. So a lender’s number one concern with a development is you’ve got to get me at least to where I have a habitable building, certificate of occupancy building. And so until you get me that, you are personally liable for the loan. Because I cannot deal with having an uncompleted building. It’s just way beyond my expertise. At least if I’ve got an existing building, I can hire Cushman and Wakefield to lease it, and I can hire somebody to– but a non-existing building is a mess, just a mess.
So that’s why they’re, first and foremost, fixated on whatever amount I give you, I have to be convinced that you’ve got the wherewithal and the expertise to finish the building. And so hence, their equity requirements in that regard and hence, their personal guarantees on finish of the building. Now once you’ve got a building, then they’ll generally go and say, OK, I don’t have to have a personal guarantee anymore. At least I know what to do with a building if I take it over, if you’ve got a certificate of occupancy. So usually I can get off a personal guarantee then.
When you talk about loan to values, it gets back to how “out there” is it, and how aggressive are the lenders. The notion is that if you’re creating– a typical building, a typical development usually has a profit margin of 20%, 25%, just something like that. And so you go OK, the magic– the ingredients of the cake, including labor, cost 80, and I can sell the cake for 100. Right? Ingredients, including labor, and oversight of the building, cost 80, and when it’s done, it’s worth 100. Because that’s the return to doing all that brain damage we talked about and managing all that risk.
Therefore, what they will usually say is I need at least 20% equity. Because what if you build it, but it didn’t create any value. What if at all it’s worth is the ingredients? And given that as a rule of thumb, they’ll end up where a typical construction loan in a typical market would be something in the range of 70% to 80% of all costs, including land, including labor, including materials.
That often translates to saying, OK, the equity in the deal is you put up the land. You go buy the land, Bruce, as the developer. You control the land. And land, let’s say, by rule of thumb– not by reality, but by rule of thumb– is 20% to 30% of total cost. So if you put up the land, I’ll put up the rest of the construction cost. And that means we end up 70% to 80% total leverage on all cost, which means if you added no value, I still am money good. Because I’m going to take your land along with everything else.
BRUCE KIRSCH: Right.
PETER LINNEMAN: And so that’s crudely the thing. And then what they will say is on replacing it with a loan loan, that they’ll say typically lenders don’t want to do more than about 70% loan to value. So I’ve got to have some amortization on this so that when your loan is due, somebody will be out there willing to make a 70% loan to take it out at what I think the value will be then. So it’s all crude. If you go to Williston, North Dakota, it’ll be less loan available with faster amortization. Because what do I do if they stop drilling? If you go to midtown Manhattan, where land is a bigger component of the price, or Tokyo, where the land is a huge component of the price, I’ll lend you more even to help you buy out the land because that’s how the math works. But that’s a crude sense of where it comes out.