
This story is part one in a BUILDER special report about the challenges facing small- and medium-sized builders. Read part two here.
Jeff Benach knows what it’s like to cheat financial death.
As principal of Lexington Homes in Chicago, Benach peered into the abyss during the darkest days of the Great Recession.
“There were times when we had to come to the closing table with $20,000 in cash just to make up for our losses,” Benach says, noting that scores of other local Chicagoland builders went belly up at that time. “We had two smaller communities, and one larger one going at the time, and that’s the one that nearly took us into the afterlife.”
But instead, Benach says he and his family bit the bullet to make sure the company his father founded in 1973, which has built over 40,000 homes, survived to fight another day.
“A lot of people ask me why we didn’t just walk away, as almost every other builder in our market did,” Benach says. “It’s because we wanted to be able to keep doing business now.”
Today, as his market has regained some of its footing, Benach has been able to go to the local community banks he’s been doing business with for years to get financing for the infill, townhome, and single-family houses he builds and sells for an average price of $350,000.
“They know that if the Great Recession didn’t break our backs, nothing can,” Benach says. “We’re very fortunate now to have the banking relationships we do.”
But while Lexington Homes’ tale of survival is remarkable, it’s also more of an exception than the norm in many markets across the country. Even as underwriting criteria have loosened generally, and credit availability has grown, smaller regional builders have been feeling the pinch when it comes to qualifying for acquisition, development, and construction (AD&C) loans from their local community banks.
“If you’re a developer coming out of the ground and looking for construction financing, the traditional bank options are fewer today than they were just two or three years ago,” says Jordan Metzger, a partner at law firm Cole Schotz in New York that advises on development deals. “It’s not that it doesn’t exist, but there’s less of it.”
Many respondents to last year’s BUILDER 100 survey indicated AD&C financing was a top area of concern going into 2018. And data from both the NAHB and the Federal Deposit Insurance Corporation (FDIC) show the growth in overall construction lending, especially from small banks, slowed somewhat dramatically in the first half of 2017 (see charts).
None of this is to say that lending has stopped completely, or that financing for builders is unattainable. There’s also reason to believe a recent regulatory regime change in Washington, D.C., could reverse the trend as early as this year. And new, non-bank lending sources that cater to smaller builders have proliferated in recent years, albeit at a price.
“We are still in a growth cycle,” says Robert Dietz, chief economist at NAHB. “The concern would be if we had two or three quarters where that growth rate continued to slow, or even turned into tightening territory.”
But there are nuances in the numbers of which builders should be aware.
“From the second quarter of 2016 to the second quarter of 2017, construction and development lending among all banks increased 10%,” explains Bert Ely, a banking and monetary policy consultant in Alexandria, Va. “But for smaller banks, there was only 5% growth year over year, and no growth from the first to second quarter of 2017. And of course, builders and developers are dealing mostly with those smaller banks.”
The current trend means that the traditional lifeblood for most small builders—a construction loan from their local bank—is harder to come by today, even as demand for housing in most markets continues to rise. Understanding the reasons behind the current lending environment, the alternative finance sources that have sprouted up in the market in recent years, and the steps builders can take to secure a loan from a bank or other lender (see sidebar, p. 63) is essential as small to mid-sized firms navigate the world of home building in 2018.
Why the Pullback?
Taken from a macro perspective, the fact that smaller and regional banks have pulled back on AD&C lending, even as demand for housing has remained brisk in most markets nationally, doesn’t quite compute. But then, in the years following the Great Recession, home building has been anything but business as usual, and banks haven’t forgotten the slings and arrows they suffered at the hands of single-family home builders.
“Acquisition, development, and construction lending was a significant factor in the failure of a number of banks following the last financial crisis,” Ely says. “Lenders had to foreclose on half-built homes, and on development projects that never got built. There were significant losses that really burned a lot of banks.”
With those experiences still fresh in many bankers’ minds, there’s now a preponderance of caution among some smaller lenders, especially as the current cycle matures into its ninth year. “The situation right now is that the economy is performing quite well,” Ely says. “But what everybody’s worried about is when do the bubbles start popping, particularly in housing?”
Joanne Brooks, vice president and counsel for the Surety & Fidelity Association of America, a trade group that represents the surety bonding industry, notes that backing builders can be worrisome for banks, even during the good times.
“Construction is risky business,” Brooks says. “Contrary to what may seem intuitive, more contractors fail and default on construction projects when the economy is in the recovery phase because that’s when they take on too much work, and then can’t find the resources to complete it. Lenders are well aware of the economic cycle and often are looking for ways to mitigate this risk.”
The ghosts of the previous housing bubble are still very real in both bankers’ and regulators’ minds. “The fact of the matter is, the regulators beat up on the banks a lot for missing the market turn, but the regulators missed it, too,” Ely says. “They want to make sure they don’t miss it again.” The result, to some observers, is that the pendulum has now swung back into overly cautious territory.
“I think there’s an argument to be made that there is maybe a little bit too much risk aversion going on,” says NAHB’s Dietz.
Increased Scrutiny
Some of that risk aversion is manifesting itself as bank regulators have eyed banks’ capitalization ratios more closely, especially in light of the mushrooming growth of the multifamily sector in the past five years. That’s impacted single-family lending, too, which gets lumped in with other types of commercial lending.
For Robert Suris, founder and principal of the Miami-based Estate Companies, which builds both multifamily and single-family projects, the effects of that boom are being felt now, especially at the regional bank level.
“The regional banks that lend in the multifamily space can only have 35% exposure to any asset class,” Suris explains. “With all the capital that they’ve deployed in the last two to three years, they’ve obviously burned into that 35%, and so a lot of them are pretty much tapped out.”
The Senate approval in November of Trump appointee Joseph Otting, a former banking industry executive, to the Office of the Comptroller of the Currency, which oversees banks, could ease that regulatory oversight going forward.
“What we’re hearing from our banking partners is that the lending environment is going to loosen up, and they’re going to let bankers be bankers again, to make decisions at the bank level,” Suris says. “That would help.”
But until that happens, many of the regional banks in his market are stuck at their current capitalization ratio limits. The irony in the South Florida market, according to Suris, is that smaller, local banks that haven’t reached their ratios have stepped in to pick up the slack—albeit at higher rates—where they can. The sticking point is that many of those smaller banks aren’t big enough to fund large multifamily construction deals, while single-family construction lending is viewed as a high-risk, low-return business. “Multifamily lending has really become a victim of its own success,” Suris says.
For Rick Muskus, president of Stamford, Conn.–based Patriot Bank, which has less than $900 million in assets—qualifying it as small, by bankers’ standards—it’s important to play in the right deals that make sense for his business. While his bank does make construction loans to single-family builders that it has established relationships with, other types of loans, perhaps for the acquisition or predevelopment of land with a short-term bridge loan, may be a better fit.
“The reason we do the bridge lending, a lot of times, is because we don’t have the capacity to provide the construction financing,” says Muskus. “For instance, a $12 million loan to provide bridge financing on the land, that’s fine, but if the construction loan is $40 million, we don’t have the ability to do that. Our strategy in that case would be to do the bridge loan at a little bit higher rate, and then be taken out by a bigger bank.”
It’s Not You, It’s Them
Patriot’s example illustrates another aspect for builders to consider when applying to banks for a construction loan: namely, how it benefits the bank’s business. Whereas a construction-to-permanent loan on a 30-unit, multifamily building could result in a multimillion-dollar construction loan that converts into a 10-year mortgage that provides ongoing interest income for the bank, doing straight, single-family construction loans has a different outcome.
“If we wanted to be a construction-only lender, we could do that eight days a week,” Muskus says. “But that’s not our goal. We’ve got growth metrics within our commercial real estate portfolio, and one way we can contribute to that is by making construction-to-perm loans. Otherwise, you’re just recycling the same construction dollars again and again.”
The nature of straight construction lending has also driven some banks to forgo that area of the business altogether. “A lot of the larger banks don’t want to deal with the administrative headache of construction draws, and going out to do inspections,” says Ken Fixler, president of Northbrook, Ill.–based Barnett Homes. “It can be quite an ordeal, and there’s a lot of expense in doing it.”
Or, as Jan Brzeski, managing partner at Los Angeles–based private money lender Arixa Capital explains, sometimes banks simply don’t want to deal with the “brain damage” in administering construction loans.
“Banks like doing big, easy loans,” Brzeski says. “You’re buying a $30 million apartment building that’s cash flowing, and you need a $20 million loan? Banks love doing that. But if you need a $4 million loan that has 17 draws and an inspection at every one of those steps along the way, nobody’s going to get really excited about that.”
Alternative Financing
Ironically, the tightening of AD&C lending by smaller banks has resulted in a somewhat positive offshoot for builders: As banks have been less inclined to make straight construction loans in recent years, a cottage industry of private or “hard-money” lenders has cropped up.
“Traditional lenders tightening their belts has been an unexpected benefit for borrowers,” says Kelly McDonald, vice president of sales at San Francisco–based RealtyShares, an online marketplace for real estate investing. “There is still a very strong appetite for these loans from private lenders who are competing for market share from the receding banks. Compared to just two years ago, when interest rates were starting at around 13% for a residential project, we’re now consistently seeing loans in the 7% to 8% range.”
As Muskus describes the growth among non-bank lenders in recent years, “It’s a big business, and it’s nationwide. There is a big contingency of non-bank financing alternatives out there for developers that are very active, especially in bridge financing.”
Formerly a licensed home builder in Connecticut himself, Muskus says that while these lenders fill a needed gap in construction financing, builders should also make sure they know who they’re dealing with in this market.
“You want to understand very well upfront what the worst-case scenario might be,” Muskus says. “Private lenders don’t have the same patience level and may have a different business model, where they’re perfectly happy owning real estate. They may actually count on it, in some cases.”
Those kinds of tactics and reputation are how these lenders earned their hard money moniker in the first place, coupled with the higher interest rates they charge. But the wealth of competition in the sector in the past three years has brought down both rates, as well as the penchant toward those kinds of aggressive business tactics, according to builders who have recently completed these kinds of deals.
Take Brian Hoffman, co-owner of Northbrook, Ill.–based Red Seal Homes. The builder’s Provenance community on Lake Michigan’s North Shore had run into some bad press as community groups tried to block it, a factor that scared off local banks. So Red Seal started talking to private lenders for the first time to see what kind of deal it could put together to keep the project alive.
“Over the years, we had heard some of the horror stories about working with those kinds of lenders,” Hoffman says. “But in our experience, they were unfounded. It was a remarkably positive experience. At the end of the day, the deal we closed on was almost identical to the one we discussed in our first meeting.”
The private lending business has become so robust in construction lending that Barnett Homes decided to launch its own private lending practice, called Barnett Capital, to fill the gap.
“We noticed there was virtually no borrowing capabilities for the local guys who were buying homes to fix them and flip them,” Fixler says. “So we started lending to guys who were doing that, and we became a good source of financing for them, because we understand the business and can act quickly to give them what they need. It’s grown into a national business for us.”
Whereas bank rates currently range between 4% and 6%, private lenders are increasingly coming in at 7% percent, though rates as high as 13%—and sometimes higher, depending on the lender and builder—are not unheard of.
Horsham, Pa.–based private lender Finance of America is a good example of the types of offers available to builders in the private lending market today.
“Finance of America’s commercial division offers funding up to 95% of construction costs with multiple draws available, and land advances up to 75% of land value,” Sara Sefcovic, director of PR & communications, says. “Loan amounts range from $150,000 to $3 million at rates starting at 6.99%.”
Where to Start
While straight bank loans are harder to get, engaging with a private lender first can help to secure a loan with a bank down the road. Nationally, builders have been turning to private lenders for higher rate, short-term bridge loans that can be used to buy land, which can then be taken out with a lower-rate bank loan once permits are pulled, and the bank is reassured by the fact that you’ve already done some of the prep work.
“Builders put themselves in a great position when the land is owned free and clear, and when plans are drawn and permits pulled,” says Aaron Norris, vice president of the Riverside, Calif.–based Norris Group, a private lender. “It shows some personal investment into the project and takes uncertainty out of the project from the lender perspective when a build-ready project is presented.”
That way, builders can use a combination of non-bank and bank lenders to make sure a project gets out of the ground, with a blended rate for the overall project that comes in lower than the higher cost of private money.
“It’s expensive money, but it’s a small piece of the capital stack, so your blended rate at the end looks a lot better,” Suris says.
Non-bank lenders also have a reputation for being able to act quickly to fund loans fast, as they are less inspection-centric than banks. Many fund draws directly, rather than through a title company. Indeed, it’s the ability to deliver the money when it’s needed that builders should look for when dealing with lenders in this area.
“It’s easy for a lender to generate a term sheet,” says Metzger, the attorney who advises on development deals. “But between the term sheet and closing is where the rubber meets the road. Builders would be well advised to research the marketplace to make sure the group they’re dealing with can close.”
In other words, just as these firms are going to take a good, hard look at a builder before loaning any money, make sure to do the same in return. While the lending environment has tightened, money is out there for builders who are willing to work for it. And with a loosening regulatory stance anticipated this year, builders looking for traditional bank financing may have an easier time in the near future. But having everything together to be able to present a clear, well-thought-out business plan can only help a home builder get a project out of the ground, no matter what lending conditions are to come.