Thursday, June 25, 2009

Construction Lending Blues

Although most of what you read about CRE loan problems refers to CMBS loans, the reality is construction loan defaults are a much, much bigger problem. The reason you hear so much about CMBS is availability bias; CMBS loan performance is closely monitored and loan level data is readily available, while construction loan performance data is extremely fragmented.

John Reeder at Real Property Alpha notes:

When you go home at night and turn on the lights, you don’t have to think about what it took for that light switch to turn on.  Somebody had to develop a power plant.  Somebody had to develop the utility infrastructure to deliver the power.  The neighborhood you live in is likely part of a development that somebody had to get approved.  The store where you buy your groceries is part of a retail center that had to be built.  It wasn’t always there.  But these are things we take for granted.  The difficulty of development does not weigh on us.

And yet development is hard.  Even experienced developers fail… all of the time.  In order to bring projects online you have to make it through a gauntlet of challenges that includes buying the land right, proposing a marketable project, obtaining environmental clearances, getting discretionary zoning actions approved, getting through construction within budget, and enduring market cycles.

If a construction project makes the headlines, it’s usually a big deal that’s blown up in a conspicuous way. For example, construction at the Las Vegas Fontainebleau hotel, pictured at left, is currently shut down as a result of the construction lenders’ unwillingness to advance funds. The borrower is in bankruptcy and and all parties are litigating (more on the story at the Zero Hedge post  Fontainebleu Fiasco Soon To Get Epic). However, big projects are just the tip of the iceberg; for every big project there are ten smaller ones in trouble.

Here’s a list of the way construction loans can go wrong. Some of these are “normal” risks in getting a development done, while others are cyclical. I’ve put the cyclical issues which are currently in play in italics.

Jurisdiction Approval Issues. This category of issues creates delays or cost overruns which put the property in jeopardy.

  • Failure to obtain necessary jurisdiction approvals. These could be big, obvious approvals (e.g. a building permit) or an obscure approval which wasn’t obvious at closing (for example, an approval for an off-site bridge over a stream for an access road to get to the project).
  • Change in infrastructure requirements or fees post closing with no grandfathering
  • Change in code requirements post closing with no grandfathering

Construction Issues

  • Costs underestimated in the initial project budget
  • Unanticipated site conditions (for example, soils problems) leading to delays and/or cost overruns
  • Exceptionally bad weather leading to delays and/or cost overruns
  • Labor or material cost increases post closing (e.g., the price of plywood goes up after the budget is set)
  • Labor strikes or unavailability leading to delays
  • Material unavailability leading to delays
  • Failure of the contractor or major subcontractor(s) due to financial problems unrelated to the project (this often creates delays or cost overruns which puts a property in jeopardy)
  • Construction or design defects (for example, water infiltration) which must be cured, leading to delays and/or cost overruns

Leasing Issues

  • Decline in rents from the original pro forma
  • Slower than anticipated lease up
  • Higher than anticipated tenant improvement costs (in a soft leasing market, developers have to offer more tenant improvements to get tenants to sign up)
  • Deteriorating financials or bankruptcy of a major tenant

Construction Loan Issues

  • Increase in interest rates resulting in early depletion of the interest reserve
  • Insolvency of or regulatory restrictions on the construction lender

Permanent Financing Issues (these issues may prevent the construction loan from being refinanced before it matures)

  • Increase in interest rates
  • Increase in operating expenses compare to the original pro forma (for example, real estate taxes assessed at a higher rate than anticipated)
  • Increase in cap rates (resulting in a value decrease such that a permanent loan can’t be obtained)
  • Tightening of underwriting standards
  • Deteriorating financial condition or credit of the sponsor unrelated to the project (for example, foreclosures on other projects)

This list is not complete, but it gives you a sense of how unpleasant it is to be a construction lender (or borrower) these days.