Developers are visionaries; whose sole focus is transforming fields and rundown buildings into stunning, magnificent structures. They visualize alluring apartment communities, sleek skyscrapers, retail center villages that cater to the many, state-of-the-art storage facilities, and luxurious hotels. Across all commercial asset types, developers are looking to be the creator of the next trend; to be the inventor of the extraordinary. With each new project, the developer faces many challenges – rezoning, cost-overruns, construction delays, and of course, funding. In addition, the developer is required to invest a large portion of their own equity as an affirmation of their commitment to the deal. This contribution of developer equity can be stifling, especially in the multifamily industry where a typical 250-unit apartment community can cost over $25 million to develop. Multifamily Industry The drive for multifamily housing has jumped in the last few years as Millennials search to live closer to urban centers without breaking their wallets. There has been an increase of more than one million new renters four different times in the past five years. Millennials desire to live close to the city, having the flexibility to move as they cultivate their careers. Apartment complexes are offering tenants extravagant living that cannot be attained affordably with single-family homes as the average Millennial does not earn enough to live in the top MSA’s around the country.

Developers are basking in this demand to provide bigger, better, world-class communities for this generation. The passion to create the next best thing is an all-consuming aspiration for developers. Sometimes this consists of flashy new amenities such as coffee houses, full fitness gymnasiums with yoga studios, leather recliner-filled movie theaters, and personal butler service. Other times, the desire is to attract the Eco-friendly crowd with units offering recycled plastic floors, water bottles issued to every tenant with a filtrated rainwater system in the lobby, rooftop gardens, composting stations, and bicycle parking/repair shops. Regardless of the concept, each project can be viewed as a long road trip with the ultimate oasis as the destination. And before the final completion of one project, most developers have envisioned the next project; scouted the land, and started the zoning process with the city.

But what happens when the money runs out?

If developers look to each multifamily construction project as a road trip then money is the fuel that gets them to the destination. What happens when they run out of fuel? To fund a new construction project, developers approach a bank with their vision. When a bank agrees to finance the project, the bank generally funds 70%-80% of the costs. This leaves the developer to invest the remaining 20%-30% using their own money, thus participating in the risk. This is often referred to as the developer having “skin in the game”. By contributing their own money, developers are announcing their own confidence in the venture’s success.

Each time a new project is developed, the developer must invest their own money into the deal. This is quite costly. Over the course of just one construction project, the developer can end up investing several million dollars. The developer quickly runs out of money to develop the next project. The end result? The developer has to stop developing. …or does he?

Construction loans are meant for the short-term financing necessary to fund the building of an asset and the loan amount is based on a percentage of the cost to build. Construction for a multifamily project usually lasts 18 months to 2 years. A permanent loan replaces the construction loan once the property is completely built, leased up, and has stable positive cash flow. The Permanent loan amount is a percentage of the value of a project rather than the construction cost. Since the value is much higher than the cost to build, the resulting permanent loan amount is much higher. Permanent loans also lock the rate for a longer term, generally 10 years.

Two Schools of Thought about Permanent Financing

The world of permanent financing consists of several options: Portfolio lenders (banks, credit unions, life insurance companies), Agencies (Fannie Mae, Freddie Mac), and Conduit lenders (Commercial Mortgage Backed Securities).

Commercial real estate mortgage brokers act as an intermediary between lenders and borrowers. These Brokers generally have two schools of thought when taking out a construction loan with permanent financing: low leverage or cash-out.

Low-leverage: Portfolio Lending and Conservative Financing

The low-leverage guys feel that utilizing a lower-leveraged loan can lead to larger cash flows for the property. After all, a smaller loan means smaller mortgage payments and the developer enjoys higher cash flow every month. Portfolio lenders are institutions that originate loans to be kept on the books as an asset to offset liabilities. These loans tend to be more conservative and require personal recourse from the developer. Banks are the common option for portfolio lenders as most developers are familiar with traditional banks due to local advertising and branches.

When it comes to permanent financing, portfolio lenders prefer the borrower maintains most, if not all, the original equity investment in the property; keeping “skin in the game”. However, this traps the equity in the property and limits the developer’s “fuel” to start a new development.

Cash-out Refinancing: the Arrival of the Fuel Stations

Cash-out refinancing, on the other hand, fully leverages the property, maximizing proceeds and creating instant money to put into the next development, thus “refueling”. This is the easiest way to obtain the funds necessary to begin the next project without dipping deeper into pockets or searching for investors. Similar to the gas station at the end of a long trip, commercial mortgage brokers can supply developers with the “fuel” necessary to make their visions a reality by structuring and closing a cash-out refinance of the construction loan. The introduction of Agency and Conduit lenders has diversified permanent financing options. These lenders tend to be more aggressive than portfolio lenders, which allows for higher loan proceeds. Compared to Banks, Agency and Conduit lenders offer much higher leverage and are more comfortable with cash-out refinancing along with offering longer terms and amortization schedules.

Taking an example of a $20,000,000 multifamily construction project, the bank funds 80% of the cost ($16,000,000) while the developer initially funds 20% of the construction loan ($4,000,000) from personal liquidity. After reaching stability at 90% occupancy, the loan is ready to be moved to a permanent loan. The permanent financing based on 75% loan-to-value yields a $22,000,000 cash-out refinance. The developer walks away from the table with $6,000,000 after paying the construction loan balance of $16,000,000….and this is a non-taxable event! The developer can choose to pocket this cash or use the money to fund the next project. This process can be repeated; recycling the initial equity to provide the down payment required for the next construction project.

No one knows this strategy better than Chris Parr; the owner of Parr Investment Properties. Parr Investment Properties, Inc. has built more than 1,800 units and continues to look for opportunities to develop new communities. In 2011, Chris Parr built Pointe at Robinhood Village, a 192-unit Class-A property in Winston-Salem, NC. For Pointe at Robinhood Village, upon stabilization of the property in 2014, Capstone Capital assisted Chris in obtaining permanent financing. By maximizing proceeds rather than low leverage, Capstone Capital was able to help Chris achieve a permanent 10-year term loan of $12,500,000 with a 30-year amortization. After paying off the construction loan debt, Chris Parr walked away from the table with $3,200,000 to start funding the construction of his next multifamily community.

Lucius Annaeus Seneca once said, “It is a rough road that leads to the heights of greatness”. The truth of that statement is clear when one is in the midst of developing the newest commercial structure. And while there may be hills and valleys throughout the path from ground to roof, in an era when developers are wrapped up in visions of creating beauty out of dirt and being the founder of the next best apartment community, no one wants to stop because they are limited on funding. No developer wants to run out of fuel in the middle of the road trip. The best way to keep the road open is to allow a mortgage broker to demonstrate the best source of funding and be the fuel station lit up in the dark night.

 

– Jackson Howard