A handful of well-trained commercial mortgage brokers are about to make a fortune originating commercial construction loans over the next few years. There are three reasons why this is true.
- There has been almost no new commercial construction in the U.S. for the past eight years. The U.S. needs a few more commercial buildings in certain areas - like office space in San Francisco and multi-use industrial space in many of the nation's gateway cities (jokingly described as cities with football teams).
- Commercial construction loans are large, so the mortgage broker's fee will be large. One point on a $4 million commercial construction loan is a handsome $40,000.
- Banks love to make commercial construction loans because they are very profitable. The bank earns one point ($40,000) to two points ($80,000) upfront on the entire loan amount (say, $4 million), even though the first draw or disbursement to pay for the demolition and grading might only be for $37,000. Construction loans are also short-term loans. Banks greatly prefer short-term loans.
Commercial construction loans can also be an enormous waste of time for mortgage brokers, if you don't know how to quickly separate the wheat from the chaff. An untrained commercial loan broker could easily originate two dozen large commercial construction loans and never close a deal.
The reason why is because the vast majority of developers don't have enough equity or skin in the game. They want the bank to take all of the risk. The problem for beginning and intermediate level commercial mortgage brokers is that they can spend dozens of hours packaging a commercial construction loan, when the deal never had a chance in heck of closing from the start because the deal lacked enough equity. Over the several blog articles, I intend to teach you how to quickly determine if a commercial construction loan has enough equity.
If a commercial construction loan does close, it is almost always made by a garden-variety commercial bank. You'll recall that a commercial bank - as opposed to an investment bank or a merchant bank - is just a bank that accepts deposits and makes business loans. The word "commercial" is just a fancy term for "business".
Construction loans have to be disbursed in stages; otherwise the developer could just skip town with his Barbie doll girlfriend and the bank's $4 million. The bank will therefore insist on making frequent progress inspections to ensure that building is being constructed according to the plans and specifications. Of all of the various types of commercial lenders - life companies, conduits, commercial banks, credit unions, and hard money lenders - commercial banks are the ones best equipped to issue a number of smaller disbursement checks.
Since construction loans need to be disbursed in stages, after frequent progress inspections, it follows that commercial construction loans are made by local banks. It wouldn't make sense for a Chicago bank to make a $4 million commercial construction loan in Dallas. You can't keep putting an inspector on a plane to Dallas every ten days. It's not economically feasible.
Okay, so an $8 million commercial construction loan falls in your lap. Do you accept the loan brokerage assignment. Well, let's underwrite the deal. To underwrite a commercial construction loan, you need to apply a number of tests and ratios. We will cover each of these tests or ratios in more detail in upcoming blog articles:
- Loan-to-Cost Ratio. Is this deal less than 80% loan-to-cost? Does the developer have enough skin in the game? Most deals will fail this test.
- Loan-to-Value Ratio. When completed and leased out (stabilized), will the construction loan be less than 70% to 75% of the property's fair market value?
- Debt Service Coverage Ratio. Will the finished property, when leased out and stabilized, generate enough net operating income to give the takeout lender his required 1.25 debt service coverage ratio?
- Debt Yield Ratio. This ratio is new, and it is different from the debt service coverage ratio. This ratio is typically only used for commercial loan requests larger than about $5 million to $10 million. If the borrower defaulted on his first payment and the construction lender immediately foreclosed, will the leased and stabilized property produce a cash-on-cash return to commercial construction lender of at least 8% or higher?
- Experience of the developer. Has the developer built and managed a number of similar buildings almost this large? Be sure to ask for a curriculum vitae ("CV").
- Is the project ready to be financed? Does the developer have his final working drawings? Can he show you an architect's rendering?
We will cover each of these subjects in more detail in the coming weeks.
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