Peter Pays Paul

As a commercial hard money lender I have to be good listener. The reason is that everyone has a story to tell about their need for money. Some stories are better than others.

What should you include in your story?

Introduction

A good literary story introduces you to the characters, the setting, and any history relevant to understand the narrative going forward. A good lending story will include some of the same attributes. Most of this information should be included in a easy to read executive summary.

• Who are the main characters? This includes the loan sponsors, and any borrowing entity that may be involved.
• What is the setting? The setting would include the property location and property type. Details are important in this section and should include: unit mix, income details, and tenant information. This would also include the loan amount and the current property value.
• What is the property’s history? This should include the property’s acquisition date, acquisition cost, repairs or construction, current liens, and any other items that set the stage going forward.

Body

The “body” of a commercial loan story should contain all the details that support the loan amount and property value. Not all hard money lenders will lend on the “appraised” value alone. Unfortunately, an appraisal is an opinion of value and not necessarily the price that the market will bear. Hard money lenders desire to protect their investment capital and want to be assured that the property can sell for more than their loan amount.

Property information and borrower information is very important in this section. The lender may ask for tax returns, income statements, balance sheets, rent rolls, leases, appraisals, operating statements, and other relevant facts to justify the loan. It is best to have these times beforehand from the borrower and be ready to provide them to the lender when they ask for it. Hard money lenders require different documents depending on their underwriting criteria.

Conclusion

When I review a deal, I want to have all the facts that are relevant to the deal. Market surveys, comps, and demographics are helpful to understand the project. The conclusion of your story should be the reason that they are searching for hard money. Is time a problem? Is the credit poor? Do they have unseasoned funds? Are there vacancy issues that will be corrected? Are they short on capital?

How to tell your story?

First, if you are a commercial broker don’t pass on a loan file that you received from someone else without reviewing it. This is the epitome of laziness and a lack of professionalism. It is frustrating to call a broker with questions, after reviewing a loan file, only to find out that the broker has no idea what the deal is because they just glanced at the package and passed it along.

Second, organize the data. Sorting through pages of data is frustrating and may mean that the borrower is trying to hide something. It is like an episode of “Law & Order” where the defendant sends over 15 boxes of documents in order to hide the document containing incriminating evidence.

Third, be as brief as possible. You may be very eloquent, but time is money. Also, a pig in a dress is still a pig. An ugly property with pretty words is still an ugly property. The executive summary should be a summary, not a life history.

Fundamentals are Still Fundamental

What do I mean? The value of a property is largely going to be based on income and cap rate. A lender is going to base their loan on the value of the property. The value may be today’s value or it may be a future value, but it will be based on a reasonable expectation of the property’s value. Property doesn’t generally appreciate at 400% or even 100% per year so take this into mind when you “estimate” your property’s value.

I get at least one phone call a day requesting construction financing. (Owens Financial Group does fund commercial construction projects on a limited basis.) Underwriting a construction loan is handled differently than a typical commercial loan.

Lenders desire to know that a developer has enough money invested in the project to motivate the developer to overcome the headaches and hassles that are bound to arise during development. A developer with too little invested, is likely to cut their losses and run, if construction problems arise, permits are not obtained, or weather is not favorable. Many lenders will underwrite a construction loan on a Loan-to-Cost (LTC) basis, as well as a Loan-to-Value (LTV) basis.

Loan-to-Cost

LTC is a ratio of the loan amount to the total project cost. Included in total project cost are all of the costs from the time of acquisition to the close of escrow.

Cost Categories

Costs can be divided into two general categories Pre-Development and Development costs. Pre-development costs are those costs incurred before any actual construction work has begun on the property. This includes architectural fees, engineering, survey, legal, entitlement, and permit fees. The property acquisition price, site work, and utility installation may also be included in this cost section. Development costs are those incurred during the actual development of the property. Development costs include site work, material costs, labor costs, overhead, loan fees and interest, landscaping, insurance, and taxes.

Sources and Use of Funds

Many lenders will ask for a spreadsheet or report that details where money was spent and the source of that money, borrower’s funds or loan proceeds. Again, this is used to determine the developer’s investment in the project.

The Devil is in the Details

Different developers account for costs differently and lenders might view developer “costs” differently. Commonly this occurs when a developer has little actual cash left in the project. The developer is trying to appear more invested in the project.

Below are some common cost “red flags” for underwriters:
Interest during the pre-development period. This is indeed an expense, however it has not added value to the land or property. Interest has no value to a future buyer, while entitlements, site work, or utility installation may.
Property acquisition price vs. property “value”. Borrowers on construction loans will often state the property cost based on a current market value. Asking when the property was purchased and the initial purchase price is a key to unraveling this knot. Value can be attributed if the borrower has taken the property through entitlement or assembled multiple parcels of land and is developing a larger project.
Management or supervision fees during development. Most lenders expect the developer to get paid upon completion and sale of the project, not before the construction lender’s risk is paid off.
Single builder/developer projects. If the developer is also acting as the builder, the cost figures might be lower than market costs for similar construction. Should the developer be unable to complete construction, the lender is going to incur a higher construction cost to bring the project to completion.

The Wrap Up

Lenders are always trying to mitigate their exposure to risk. A well capitalized developer, that is invested in the project is more likely to bring the project to completion and to mitigate the lender’s exposure to risk.

Funding construction projects requires gathering the proper detail from the borrower. It also takes an understanding of lender requirements. Different lenders will ask for different documents and schedules. Knowing in advance what they require and acquiring that information from the borrower will speed your loan approval process.

Happy New Year and Success in 2008!