Since the beginning of the COVID-19 pandemic, construction lenders have been reluctant to choose the development projects they are pursuing. Even if construction financing is not without its challenges, with the right sponsor and the right vision projects can be capitalized and financed.
At the beginning of the pandemic, many construction lenders hit the pause button to assess the situation, run stress tests on their existing loans, and postpone commercial real estate workers to enable COVID-related relief loans. They eventually returned to construction loans, albeit at a generally lower loan-to-cost, or LTC, level; wider all-in coupons; and with stricter recourse guarantees.
Now, lenders are selecting construction contracts with recurring borrowers who are developing bespoke, pre-approved industrial and apartment buildings in the New York City and Gold Coast markets – Hoboken and Jersey City – as lenders have reduced the risk of issuing those loans. An existing custodian bank relationship also helps.
At the regional level, we are seeing a slowdown in the economics and performance of assets in New York City and Gold Coast that are specifically tied to COVID-19 residential use trends, including short-term tenants’ desire for more green space and cheaper rents in the suburbs.
The credit market is not naïve to this recent phenomenon; However, many in this area have taken any additional implied risk by lowering their LTC base and demanding additional recourse. Additionally, the appetite for apartment buildings in New York City, Hoboken, and Jersey City has recovered more than expected as many lenders console themselves with recent positive vaccine news and the ability to ship products in three or more years.
This reduction in senior leverage has forced developers to put more capital into the project during construction, or opened the door for subordinated debt to raise the capital stack from around 55-70% LTC to 80-85% LTC with one more expensive preferred equity or mezzanine loan to capitalize on the project.
Subordinated liabilities are usually valued in the low to mid double-digit range and, depending on the willingness of the senior lender to have a subordinated loan paid out during the construction period, can be structured as a current payment or provision. If the loan is accrual, it becomes due once the property generates cash flow to pay both senior and subordinated lenders.
The result is twofold: higher mixed capital costs to complete the project and higher total project costs. Since the sales market for investments, especially for apartment buildings and industrial plants, has improved as a result of the COVID-19 pandemic, we see two things: 1. The appetite of subordinated lenders has increased; and 2. Borrowers have recognized the inherent value of intermittently raising higher yielding subordinated debt when they hold the majority of the equity in the transaction and can capitalize on the uptrend through aggressive permanent refinancing with a GSE, conduit, or insurance company, or bank lender. Given the strong macroeconomic tailwind in the industrial and apartment building sectors, both lenders and borrowers find solace in these changing structures.
If a borrower is willing to be flexible with their capital structure, the senior and mezzanine bond markets remain extremely interested in getting projects off the ground. At the end of the day, value is generated and realized upon project completion and rental stabilization. If a borrower is willing to take on additional incremental structures and higher cost of capital, a deal will find a home and hit the finish line.
Thomas Didio is Senior Managing Director at JLL capital markets.