The decision to become a multifamily real estate developer is not made lightly. But for a person or team with the right ambitions and temperament, it is an exciting endeavor—with a fair share of risk and opportunity for reward. One of the biggest challenges of real estate development is property finance and investment. A developer’s financial needs change as the project proceeds and the sources and conditions of financing change.
Financing is typically most difficult for a developer’s first project, since the developer will inevitably face unexpected situations and, most likely, crises of various degrees that could upset the project budget and timely completion. To complicate matters, a new developer will have a limited credit history, comparatively speaking, and will most likely be an unknown figure to lenders. Financing, therefore, will require more searching, negotiating, and documentation to obtain.
Multifamily real estate development requires a broad range of skills backed by deep knowledge. A firm understanding of the financing process is an absolute necessity.
Property Finance and Investment Step-by-Step
Securing financing is time-consuming, labor intensive, and full of paperwork. It is possible that you will need several intermittent loans before your project is completed, and each of them will have different conditions and qualification requirements, as well as their own application processes. If you can combine steps, it’s highly desirable; otherwise, a typical financing process might look like this:
Purchasing the Land
Choosing a site and designing your multifamily development often go hand-in-hand. Land for development can be acquired through a simple commercial mortgage. The conditions you are offered will depend heavily on your experience and creditworthiness, and you will probably need to make a down payment of 25-35 percent of the total cost. You will also need to write a detailed, well-researched business plan, get your personal finances in order, and line up a team of professionals (lawyer, accountant, architect, and contractor) before you approach a bank. But remember, banks are businesses, so you should shop around even if you get a favorable reception at the first bank you approach.
Preparing Your Land
There is always a lot to do to prepare a site for construction. There may be buildings on the site that need to be razed; infrastructure, new roads, and sidewalks to add; and you may need to excavate basements and foundations. This is also the time to attend to permitting, zoning, and environmental compliance. Needless to say, all of these upgrades and changes—referred to collectively as horizontal improvements—are expensive. Moreover, the real estate development financing needed to carry them out can be difficult to obtain because of the risk. That is, you are replacing the mortgage on your land as well as paying for the development work with no more collateral than you had previously—a plot of land (and a plan).
Construction Begins at Last
A construction loan will replace your previous financing and provide you with the funds to build your multifamily project. Again, you’ll be looking at a large loan collateralized by property that is only about to come into being, so conditions are going to be tough and subject to complex negotiation. Local market conditions and the projected income your project will generate will be considered. You’ll need to make a good impression, too. The quality of your business plan and the reputation of your team, particularly your general contractor, will matter to the lender.
Local banks provide much of the construction financing. A construction loan traditionally requires a high down payment—possibly up to 50 percent—and carries a high interest rate because it is risky and intended to be replaced as soon as construction and tenanting are completed. It typically also requires a personal guarantee to complete the construction and to repay the construction loan. Loan funds are disbursed in a very particular way, too. After current expenses are paid, funds are released in regular installments to meet your financial needs as they arise.
Bridging the Finance Gap
Your project is considered completed when construction is finished and the property is fully occupied. At that time, you can refinance your project and receive much better conditions on the new loan. This is called permanent financing. But what happens if residents are slow to lease, your construction financing runs out before construction is finished, or your lender refuses to approve a large expense? There are innumerable additional expenses that can arise, budget items that can be miscalculated, delays that have costly consequences, and other problems that you could not possibly have planned for. Meanwhile, there are operating costs, payroll obligations, bills, and other financial responsibilities that you must meet.
In those circumstances, there is a range of finance products available to you. If you are unable to cover an expense with your construction financing, you may need to turn to a private lender for a relatively small, temporary loan. This is called a hard money loan, and it usually very short-term with high interest. When hard money is used as a stopgap while you seek permanent financing, it is referred to as a bridge loan. If you are able to get a bank loan or other institutional loan for this purpose, it is called mini-permanent (or mini-perm) financing. A mini-perm is preferable to a bridge loan because it is likely to have better conditions, such as lower interest, and, since it comes from an institutional lender, a credit record for your project will be created, which it would otherwise lack.
Permanent financing is a new mortgage. After the challenges of finding development and construction financing and bridge loans, and living with the conditions of them, obtaining permanent financing will be a welcome relief. That doesn’t mean it will be simple, however. You may find that there are more lenders willing to deal with you now that you have a beautiful new real estate project to use as collateral and that the conditions they offer will be better, but the offers will be complex and vary widely. You are going to live with this loan for a long time, so choosing the best offer is important.
Alternatively, you may decide not to hold your development for years to come. This is the natural time to sell the project, as the rate of return on your investment in the project will be lower from now on. There will be tax consequences from the sale that you will have to consider. One of your options is to use a 1031 exchange. You could, for instance, exchange your completed development for land on which you could build your next multifamily project, subject to the numerous constraints that successfully carrying out a 1031 exchange involves.
Partnering for Success
Property finance and investment is often most successful when working with a partner that has a more extensive development record, more professional connections, or their own financial resources. Multifamily development is always a team effort and establishing a partnership with a more experienced developer can have positive results that extend to future projects as well.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and multifamily real estate valuation to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country and employ a team of experts who can help you hone your investment strategy.
For more articles like this one, check out our investment strategy blog posts.
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The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
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