Behind the conceptual simplicity of financing commercial real estate development using a construction loan followed by permanent financing, lurk conduit loans, hard money and bridge loans, mini-perm and mezzanine financing, and more. These are sophisticated and specialized financial products that are not as complicated as their names might suggest, and you need to know their meanings to function successfully as a real estate developer. With this in mind, let’s briefly examine each.
The Essentials of Financing Commercial Real Estate Development
Let’s start by looking at the traditional construction loan. It is sometimes referred to as an ADC loan, because of its component parts of acquisition, development and construction loans. These loans are used respectively to acquire land, prepare it for construction, and build on it. Each can be secured individually, but financing is much simpler when your construction loan is an ADC.
Construction loans are funded in disbursements at regular intervals or as needed, and you pay interest only on the portion of the loan that has been disbursed. That interest will be on the high side relative to an acquisition loan, which is collateralized by the purchased asset. In this case, that asset—your development—doesn’t exist yet. This means that the loan has a relatively high level of risk. When your development is completed—built and occupied—the level of risk associated with it drops significantly. That is why the construction loan is refinanced at this point with permanent financing that features 7-10 years of term, typically with an initial interest-only period, and then is based on a 30-year amortization schedule.
Note that you are still not the ideal loan applicant. You have a property that will serve as the loan’s collateral, but there is no credit history to go with it yet. Not all borrowers are equal to start with, however. If you are an established developer with a good reputation, you might be offered a conduit loan as permanent financing. Conduit loans, otherwise known as commercial mortgage-backed security (CMBS) loans, have better conditions than typical construction loans because of the way they are handled by the lender. Conduit loans are pooled together and used to back bonds that are sold to institutional investors. Because of this, however, there are certain conditions that are strictly enforced. This is particularly true for rules about insurance and prepayment, which are more complex than for portfolio (non-conduit) loans.
Another desirable financial product available to highly qualified borrowers is the construction-to-permanent loan. This is even more convenient than an ADC loan, incorporating the entire finance process into one agreement with conditions that transition from construction-type to permanent as your development progresses. Besides simplifying the financing process tremendously, it may allow you to lock in an interest rate on your permanent financing before construction starts. This is an advantage when interest rates are rising. There is a downside, however: If you suffer an unforeseen setback in the course of construction, the bank can alter the conditions of the loan arbitrarily or maybe even cancel it.
Financing a Shortfall
A lot of things can go wrong in a project as large and complex as a real estate development, and when they do, there are often financial repercussions. When you need extra money fast to hold you over until other arrangements can be made, you pay a premium for it. Such a high-interest, short-term loan is called a hard money loan. It is usually provided by finance companies or other non-bank sources. You might need a hard money loan for some unexpected reason in the middle of construction, but developers most often turn to hard money lenders if their construction financing is used up before they find permanent financing. This specialized use of hard money is called a bridge loan.
If you are able to get a loan from a bank to see you through until you find permanent financing, that is called a mini-perm or mini-permanent loan. There are two advantages to a mini-perm. First, a bank is likely to offer better conditions on the loan than a private lender. Second, a bank loan will provide you with a credit history, which will make it easier to find permanent financing.
If you are developing a large project, you might want to use mezzanine financing for a portion of the cost not covered by your construction loan. It is not unusual for that portion to be as high as 40 percent. A mezzanine loan is not a mortgage. It is a very high-interest loan in the second lien position that is secured by shares in the borrower’s company. This would be stock in a corporation, but your development is more likely to be organized as an LLC, which is divided into membership interests.
Company shares are personal property, whereas a building is the property of a corporate structure. If the borrower defaults on a mortgage, foreclosure can take many months, but the procedure to seize personal property in this situation is much faster. If you don’t make your mezzanine loan payments, the creditor can seize your company, and your development along with it, within weeks. The mortgage holder’s interests remain protected, since it has the first lien, but the company then belongs to the second lien holder, at least to an extent. Because of the complexity of mezzanine financing, it takes a long time to finalize and is only used for large projects.
One of the most reliable ways to navigate the complexity of financing and obtain the highest quality of financing possible is to partner with a firm that specializes in developing and managing properties. You can benefit not only from the knowledge and experience of a large partner, but also from its history of creditworthiness.
At CWS Capital Partners, we are a fully-integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We own and manage luxury multifamily investment communities in major markets around the country, and we employ a team of experts who can help you hone your investment strategy.
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