CONSTRUCTION FINANCING 101

CONSIDERATIONS AND NOTES TO PROPERLY STRUCTURE

YOUR CONSTRUCTION DEBT

In this article, we’ll examine some of the basic concepts and terms that are involved in construction financing. In reading through this article, assume we have a typical owner/investor in the position of “Borrower”, and this person intends to construct a new facility to operate out of after having leased space for the previous 15 years. The Borrower’s existing facility is at capacity, and the prospect of owning both the company’s real estate and operating business is quite enticing (but please note: the pros and cons of having a company’s working capital otherwise tied up in real estate versus the operating business is a separate and lengthy subject altogether!).

In keeping with Alberta’s industrial roots, let’s assume the intention is to build a 30,000 square foot industrial facility consisting of 25,000 square feet of shop/warehouse, and 5,000 square feet of office.

1. Scope of Work

One of the first things a Lender will want to see is a Scope of Work. At a high level, this will entail engaging an architect and various other professionals/consultants together to ensure clarity on what is being built, how it’s going to be constructed, and where it’ll be situated. The details will also include what the mechanical, electrical, landscaping, building envelope and roofing systems will look like. To get an accurate quotation from a construction company, a detailed Scope of Work is required. Gaps in the initial Scope of Work and a failure to create a detailed design will inject significant risk into the financial viability of the project. Further, it’s unlikely a loan application will get across the line without a detailed Scope of Work – this could either lead to project delays or failure to get the project underway. To mitigate this risk and/or time delay, it is always advised to have the design team work to some extent with the construction team to ensure that the architectural vision remains feasible within the limits of the project budget, schedule, and proforma, and the financing available in the market for a similar project.

2. Loan-to-Cost (LTC) versus Loan-to-Value (LTV)

LTC or LTV – similar acronyms, but they mean two very different things. LTC represents the percentage of the loan amount against the actual cost to complete a project or build a facility. This is not to be confused with LTV which represents the percentage of the loan amount against the final appraised value of the asset.

In keeping with our example, assume the Borrower’s 30,000 square foot facility is priced at a blended rate (between office and warehouse) of $200 per square foot (for Base Building + Office build-out) for a total cost of $6,000,000. Assuming the Borrower is able to secure financing for 75% of the construction cost, a Lender will advance (in stages) a total of $4,500,000 in construction funds.

Assuming that everyone did the math properly at project onset, and the completed appraised value as determined by an accredited appraiser is $6,500,000, the LTV in this case would therefore be almost 70%.

Lenders funding the project construction will evaluate both the LTC and the expected LTV as part of the underwriting analysis. Both play a significant role, but for different reasons. For more on this topic, look for our next article in May regarding interest rate risk, and how LTV, LTC and Debt Service Coverage (DSC) can impact your ability to finance your project.

3. Cost-to-Complete Basis

Simply put, every Lender wants to fund a project that will be completed. Lenders are not Landlord’s, and they don’t want to get into the business of owning real estate unless absolutely forced. This leads to the concept of Cost-to-Complete which dictates that a borrower must inject his or her own equity into the project first, and then the Lender’s funds will follow. If the 1st mortgage construction Lender allows subordinate debt, the order is the same where Borrower equity goes in first, the subordinate Lender’s funds go in second, and finally, to ensure project completion, the 1st mortgage Lender’s funds go in last.

Back to our scenario, the Borrower would cover the first $1,500,000 of project costs, and the Lender (or Lenders) would contribute the last $4,500,000 to complete the project.

From a practical perspective, this sequencing of project funding makes considerable sense. The Cost-to-Complete basis protects the Lenders capital so that it can be repaid and redeployed. The idea is that if the Lender (or Lenders) advance project funds first, the project may well be 85%-90% complete before the Borrower would put its first dollar in. If that dollar isn’t there for whatever reason, there’s a big problem on everyone’s hands. By having the Borrower contribute from the onset, it greatly reduces the risk to the Lender knowing that its funds will not be stranded in a project.

4. Change Orders

The dreaded Change Order. As diligent as the Borrower and its design and construction team may be in outlining what will be built and how it will be built, it is still likely Change Orders will be required for successful project completion. A Change Order typically entails a change to the scope of work be it voluntary (an optional change requested by the Borrower to improve the project outcome or design) or involuntary (a forced change due to one or more unseen variables not picked up during project planning, or as a negative consequence of something project-related). In either case, the changes will increase the original project budget. The question then arises: what capital source will cover the budget increase?

In most construction loans, the cost for Change Orders are handled directly by the Borrower – remember, the construction loan (LTC) was established on the pre-determined and approved construction budget before the first shovel touched dirt. However, the impact of Change Orders can be mitigated through the establishment of a robust contingency allowance. Drawing back to our example, if there was an item that was missed that adds $200,000 to the overall cost of the project (3% of overall budget), if the contingency allowance doesn’t cover this, then it would fall to the Borrower to make up the remaining shortfall.

Most lenders will require a contingency allowance of 2-5% of overall project cost, so this particular example wouldn’t require the Borrower to pull out his or her cheque book. However, as the pressure is always to increase margin, budgets can be compressed as low as possible to improve ROI upon project completion. Change Orders should therefore be noted as a potential significant project and financial risk if a budget is too skinny along with a compressed contingency allowance. One last note, irrespective of Change Orders or budget overruns, the funding injected by the Lender will still be based on a ‘Cost to Complete’ basis.

5. Quantitative Surveyors/Cost Consultants

Another piece of the construction puzzle relates to how and when funds are disbursed. Enter the Quantitative Surveyor (“QS”) otherwise known as a Cost Consultant. In many instances, lenders will require the Borrower to engage a QS to perform project inspections at various stages to generate reports outlining with great detail the status of the construction project. Each report will also have a recommendation to disburse a certain amount of funds to pay invoices related to the project based on percentage completion of the various project phases. For example, the QS would inspect the Borrower’s project and note that the mechanical and electrical phases of the development were complete, and the cost to get to that point was $1,250,000. Assuming no deficiencies were noted, and the Borrower’s draw request (based on invoices received) are in line with the QS’ estimation of the cost to complete the electrical and mechanical phases, the lender would then fund that amount. Note that most lenders will require the Borrower to maintain a 10% holdback on each construction draw to protect against any issues related to Builder’s Liens.

Most commercial construction projects will require the engagement of a QS to act as a liaison between the lender, the client and the General Contractor. The role of the QS is to act as an unbiased source of what work has been completed and what funds should be advanced. A sophisticated QS can keep a project on track and on budget by ensuring all parties have an accurate understanding of where a project is from a cost and progress basis. They are a check-stop for a lender to ensure funds are only being disbursed based on work actually completed.

To Conclude:

In the preceding paragraphs, we’ve outlined 5 general concepts related to construction financing. As you may imagine, we have only touched on a portion of the various items, concepts, and requirements that go towards financing a construction project. For the sake of the length of this blog article, we have not outlined information respecting the different types of construction contracts (Lump-Sum, Construction Management, or Design-Build), we have not detailed the difference between soft-costs and hard-costs (and how a lender typically views these costs), we have not addressed how the initial loan advance may be predicated on Pre-Leasing or Pre-Sales, nor have we discussed the risks associated with site selection, soil condition, general contractor selection, and overall project team coordination.

Given our experience in construction financing, we would be happy to work with you to ensure as many project risks are mitigated, and the appropriate partners, deal structure, and financing are put in place to make your development a success.

If there is a topic you would be interested in seeing us discuss, please e-mail info@nationalcmc.com.