An overlooked element of attaining a successful return by developers is the appropriate financing strategy. With lenders requiring more information, the entire process of development will be delayed. Thus, it’s of importance to hire a commercial mortgage broker to handle the lending process for achieve the desired timeline.
1st Financing Option – Construction Financing:
With the change in the market for apartment buildings, developers who provided the right product in a well timed entrance proved to reap significant returns. Developers build apartment for various reasons including but not limited to, expanding their portfolios and establish a steady flow of revenue by developing their spare land.
The first step in securing financing is to showcase that the project is viable to a potential lender.
From a lender’s perspective, it is to assess the risk associated with starting a new project. The challenge comes to play when the history of the developer’s previous projects is looked at and in comparison to the asset class to see if such a project is worth the financing. A lender will also see the riskier option in a new apartment development compared to purchasing an existing apartment. The issue with new apartments is that it offers no history of rents achieved and costs incurred, the asset class itself offers little in the way of back data to give the lender confidence. It’s not common knowledge with ledgers that niche markets like student and seniors’ housing offer a substantially higher return per square foot.
Providing a feasibility study will illustrate to a lender with the needed data that shows the potential return of a new development. The utmost confidence is imperative for developers to showcase to a potential lender.
The Construction Budget:
In a niche market like apartment development, experienced developers will have a clear advantage compared to new comers who need to learn new construction techniques, new designs, new ways to market the project, time and expense. These requirements usually deter potential developers from entering the market.
Once a developer has decided to enter the market, the following metrics such as building’s construction costs, its ongoing expenses, projected renters and the number of potential tenants who are able to pay should be included in the feasibility study. These data may be hard to find but with brokers it can be attained. These figures should provide a strong foundation to convincing a lender to provide you the needed financing.
Understand The Cost:
The cost of purchasing a land affects the rent you ask to potential tenants with the advantage going to developer who obtained land long before today’s high priced market.
In one aspect, condominium projects are less affected in construction costs to apartment projects because of condominiums projects inability to pre-sale their units before building them. the lending appetite becomes a moving target, often forcing the developer to spend more time sourcing the solution that enables them to achieve their required return. Thus, developers need the right mix of unit, right target market, at the right location and confidence to demonstrate to a lender to undertake in the project. A pragmatic approach is required so that expenses don’t increase greatly as new buildings tend to provide lower cost of utility and maintenance.
As few apartments have been built since the early 1970s, there are no good references for rental rates. New apartments will show a leap for rents compared to nearby established properties, but you should justify such rents by ensuring your new build has a high level of finish. Renters today, many of whom are leaving home ownership, will expect good amenities and good quality construction, and this will push up the perceived value and subsequent premium rents. This is the balance developers of new projects will have to maintain in order to build confidence in the rents they are projecting.
A lender will require approximately 25% of equity from the developer before a loan is given by the lender. For example, on a $40 million building, $10 million has to be spent by a developer. Current market value not the price it was purchased at can be part of the developer’s initial investment.
Once the developers provide an acceptable budget with costs comparable to industry standards, the lender will advance money based on an analysis of costs in place and the cost to complete the project.
To protect a lender’s position in the stake, a lender will provide the capital in a timeline so that they are forced to either put more money into the building than previously negotiated or be left with an uncompleted building. The progress of the project is checked by a quantity surveyor or project monitor and the developer bares the cost of conductor. If the cost of construction goes out of budget, only the the developer will be expected to inject any additional funds to cover them, and not the lender.
Finishing the project:
As soon as the structure moves beyond the first couple of floors, funds for marketing expenses will be given and a developer should have a model unit available and have started marketing his project to prospective renters.
Once the project is substantially complete, construction financing will be replaced by permanent financing. This takes place when rental income is equal to 75% of projected gross revenue. From a lender’s perspective 75% complete of construction is a building done, as long as the renters are there, and assuming you are achieving the rents you have projected.
At this final phase of construction, a developer should asses the option of continuing to work with the construction lender to position for a take-out financing or find another lender. It may be advantageous to consult an experienced commercial mortgage broker to analyze the market options can make a dramatic impact on your final equity requirements, and the subsequent rate of return you will be able to achieve on the project.
With new apartment developments, developers will need to include personal guarantees as well as from potential investor partners. A new apartment project has no history and perceived performance risk.
A Commercial mortgage broker is need by a developer to negotiate with various lenders and present the best options. Lenders will show better condominium understand than apartment as lenders themselves haven’t been exposed to the nuances of new apartment construction.
The Canadian Mortgage and Housing Corporation (CMHC) can be considered as viable option as a lender. Developers will need an expert to independently make an application and see if CMHC’s solution meets the needs and expectations of the developers compared to a conventional lending source. One of the deciding factors in assessing whether a CMHC application makes sense is to assess whether a high enough loan amount and reduced interest rate are enough to warrant the premium’s that are charged for the application.
Because people have not been building new apartments, it will take time to gather the information to gain confidence that the project makes sense and to determine the highest level of financing available and the balance of equity to make the project go.
Mezzanine financing is provided by non-bank lenders who take on risk at higher interest rates. Bank lenders will provide for 65% of the value of the project with the rest, 35%, financed by the developer and mezzanine financing is there to provide for the rest.
With a mezzanine lender, you have a partner who will inherit some of the risk and amount of equity so the developer has the opportunity to invest into other projects. A developer will gain a great profit on their investment when return on the non-bank investment is higher than the interest rate of the mezzanine lender.
Contact us if you need assistance in closing the gaps in financing your investments with mezzanine financiers we work with.
Mezzanine Loans are generally capped at the lesser of 85% of completed value or 90% of project costs.
Joint venture equity is provided selectively for up to 75% of the residual equity requirements of construction projects.
Joint Venture equity is structured on a senior preferred basis to the developer’s equity contribution, which may include free and clear land.
Merchant Apartment Builder:
To build a project as large and complicated as an apartment building, it may be difficult for an individual to finance the entire project alone as apartment buildings require a significant cash down payment which can be 20-30% of the total cost for the project. A developer may not be capable to taking both the financial responsibility and risk associated at the beginning of the project. An investor may have enough money but maybe not the expertise and that’s where the difference between a merchant builder and a conventional builder comes into play. A conventional builder finances, builds, and owns a development which enables the individual to gain all of the profit along with the attached risk. With merchant builder structure, a developer becomes a merchant builder by partnering up with an investor to share both the profits and risk. The investor puts up the money, essentially buying a building in advance (a forward sale). The developing partner then builds the building, and the two cooperate to sell it to an end-buyer (which may be the capital partner or a third party). The trust factor is very important so the developer has to trust the investor to be there when capital is needed for most of the project and the investor has to trust the developer will be on schedule, to specifications and leased-up at the pro forma rate.
Merchant Apartment Builder Issue:
Bringing in a partner does complicate the process. So we are here to provide recommendations in every step of the process:
- We will assist in the assembly or acquisition of the land.
- Complete a feasibility study.
- Work with the design team.
- Structure an offering memorandum for the development to be built.
- Work closely for the lease-up.
- And, finalize the process with settle the sale of the building.
Becoming a merchant builder allows a developer to build bigger projects with far less risk, while still retaining a good return on his or her investment. A capital partner gets a good return on his or her investment with limited risk.
consider a proposed $40 million apartment complex. The initial equity that must be provided before a financial company will loan the remainder is $10 million. Of this equity, 90% ($9 million) is provided by the capital partner, and 10% ($1,000,000) comes from the developer. This secures a construction loan of $30 million, with the mortgage covenant assigned to the developer.
Let us say that the building takes two years to build and is sold to an end-buyer for $45 million, generating a profit of $5 million. After paying off the construction loan and taking back the equity, the time comes to divide up the profit.
The first thing to do is to pay the return on the equity the capital partner and the developer have paid into the project. Assuming a preferred return of 10% on the initial equity invested (agreed to at the start of the project), the capital partner is entitled to $1,000,000 per year, or $2 million. The developer also gets a 10% return, translating to $400,000. Thus $2.4 million of the $5 million profit is paid out in preferred return. The remaining $2.6 million can be paid out in a 50/50 split, or $1.3 million each.
Thus, based on an initial investment of $9 million from the capital partner and $1,000,000 from the developer, both parties get that equity back, and the capital partner gains a profit of $3.3 million, and the developer gains a profit of $1.7 million.