- August 12, 2014
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One of the most important aspects to achieve the desired rate of return that developers of apartments often overlook is acquiring financing for their projects. The financing process has changed; lenders require more information and take a conservative approach to lending, making this a time consuming component of development that will tie up considerable equity. When all these factors are considered, hiring a commercial mortgage broker to manage the lending process is essential for the developer to achieve their desired results.
The Benefits of Developing
For the past three decades, market rents were not high enough to justify the construction of new apartment buildings. Over the past five years, however, economies changed, and developers proved that the right product in the right market can reap considerable returns. The reasons many developers have started building new apartment buildings again are as varied as the developers themselves. Many are looking to expand their portfolios or enter more specialized markets and have found, in this heated market, no apartment stock available to buy at the right price. Others have spare land available from a developed subdivision and, rather than sell that land, they want to develop it into an asset that provides a steady revenue stream to help support their growth during slower build-out periods. There are numerous benefits to developers in building new apartment stock. For condo developers and homebuilders, a rental property turns an unproductive piece of land into a revenue stream that will help carry a developer through periods of slow growth. As demand for new stock is strong, as a result of supply being repressed for decades, new apartments garner substantially higher rents than older stock, and can offer higher rates of return if positioned properly by a strong and experienced manager.
Building Confidence With Your Lender
The first task in applying for financing for a project is to convince a lender that the project is viable. The challenge here is that lenders, before lending out money, carefully assess risk based on criteria that new projects have a hard time meeting. Lenders look at history, at the developer’s previous projects and at the performance of the asset class in general, before deciding that a project is worth investing in. A new apartment project is a riskier investment for a lender than a purchase and repurposing of an old apartment. By definition, a new apartment has no history. Not only does the project itself offer 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. There has been very little new construction in Canada since the 1970s, and promising new markets such as seniors’ housing and student housing remain largely hidden from a lender’s data bank. While current experience shows that rents received from new apartment construction are substantially higher than trends dating from the 1970s would indicate, and that niche markets like student and seniors’ housing offer a substantially higher return per square foot, this is not common knowledge among the lenders, yet. So the first task of a developer in gaining financing for his or her project is to provide the data that shows the potential return of a new development. This can often come in the form of a feasibility study. The developers themselves must have supreme confidence in their numbers, or they will never transfer that confidence to a lender.
The Development Budget
In new construction, there is an advantage to developers who have been building a while and have a number of projects under their belts. Developers just getting into the field often need to hire third parties in order to get confident enough to go forward on a project. They need to learn new construction techniques, new designs, new ways to market the project. For many potential developers, the time and expense in entering new markets stalls the decision and makes many walk away. Developers that take the leap need to gather data on their project, and provide good estimates of the building’s construction costs, its ongoing expenses, and its projected rents. The prospective developer must be confident that the market has a sustainable number of potential tenants who would be able to pay the rents that justify the building. These numbers must be gathered in a feasibility study that, if done well, will convince the lender to back you. This data may be hard to find, especially in niche markets, such as student and senior housing, which are not effectively covered by the Canadian Mortgage and Housing Corporation. However, brokers ((see comment #9)) with experience in these fields can help you build a strong case for your project.
Control Your Costs
It is important to control your costs from the beginning. Developers who are sitting on land that they bought years ago when it was cheap have a distinct advantage over developers buying land in today’s heated market. Remember that the more you spend, even before construction begins, the more you will have to get from rents later on in order to cover that spending. If you design a condominium project and you’re wrong about construction costs and demand, typically you are only out the cost of a sales trailer and the marketing costs, as most condominiums pre-sell their units before they build them. In an apartment building, a wrong decision is a lot more costly, since the apartment is typically already built before the mistakes become clear. Developers need to design in the right unit mix, focus on the right target market, choose the right location and be extremely confident about their risk, or a lender will not share that risk with you. Moreover, with the landscape perpetually changing, 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. When gathering data, developers tend to be optimistic on the expense side – and for good reason. A new build will have a lot of advantages in terms of lower utility costs and maintenance costs compared to an older building, but it is important not to go overboard. The hardest number to gather will be the projected rents. 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.
Lenders Looking Over Your Shoulder
Any new project requires roughly 25% equity to be put into it before a lender will approve a loan. On a $30 million building, that’s roughly $7.5 million that a developer has to spend. The initial investment from the developer can include the cost of the land (and this is the current market valuation, not the price the developer paid when the land was acquired years ago). 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. The lender distributes the money in stages so that he or she doesn’t end up in a position where they are forced to either put more money into the building than previously negotiated, or be left with an uncompleted building. These advances are often reviewed by a quantity surveyor or project monitor. This professional oversees the project and advances money on a schedule after satisfying themselves that the costs in place are occurring according to that schedule. The cost of this professional is borne by the developer. It is at this stage where projects often run into difficulty. If construction costs get out of control, the developer will be expected to inject any additional funds to cover them, and not the lender.
Finalizing the Project
Marketing costs are included as a budget item, and funds for marketing will be loaned as soon as the structure moves beyond the first couple of floors. It’s at this time that 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 usually occurs when rental income equals 75% projected gross revenue. A building can be considered done from a lender’s point of view as early as 75% done from a construction point of view, as long as the renters are there, and assuming you are achieving the rents you have projected. More importantly, it is at this stage when the developer has to assess whether it is more advantageous to continue working with the construction lender to arrange take-out financing, or whether there is an alternative lender that would be more suitable at this stage. Having an experienced commercial mortgage broker to assess your 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.
Because a new apartment project has no history and a lot of perceived performance risk, the equity required includes personal guarantees from the developer and the potential investor partners. These people must be prepared for covenant support for the project – they need to put their names behind their money. No developer is getting unsecured financing in today’s economy. The lenders want the developer to have “skin in the game” to ensure the success of the project through the construction phase until there is a sufficient occupancy level to provide a return on their investment. In the buildings that are being built, the developers have analyzed the risk and looked at the reward and have established confidence that they will succeed in building and filling the units.
To CMHC or Not CMHC
Developers need an experienced and active commercial mortgage broker to negotiate with various lenders and present the best market options according to their expertise. You have to shop around with knowledge. Developers will find that the initial lender response will be geared more to condominium experience, as even the lenders themselves haven’t been exposed to the nuances of new apartment construction. Canadian Mortgage and Housing Corporation (CMHC) will need to be considered as one of the lending options. 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. At SVN Rock Advisors Inc., we have strategies that we have utilized for developers to make the financing process work as effectively as possible and reduce the equity required to start a project. If structured properly, there are many techniques to minimize the equity required by the developers. These vary depending on the circumstance. Please contact us.
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