Last week I posted on two of three critical players in real estate development: buyers and sellers.  The third wheel, if you will, are the banks.  Most developers and investors use leverage, loans, to acquire and then develop whatever it is they’re working on. Some use less than others, some do all cash deals, but at the end of the day development deals typically have some level of leverage involved.  For all the reasons that don’t need repeating here banks continue to be very reluctant to lend in general, and even more so on development deals.  

Generally speaking, when a developer acquires a piece of land or other development parcel and looks to finance it through a lender, the “deal” if it’s available, is/was something like this:

• 25-30% of acquisition cost in equity (cash)
• The bank finances the remaining 70-75% of the initial acquisition
• The lender also offers construction financing of 100% of the construction cost, assuming that the expected finished value (as determined by an appraiser) is at least 20% more than the total costs.

There are other variables, and of course all banks have their own guidelines, but the structure laid out above was not uncommon.  In terms of real numbers, here is a rough example:

• Buy a piece of land for $400,000 - put $120,000 down in cash, with the bank financing the remaining $280,000
• Spend $250,000 on construction, with the bank financing it
• Total debt upon completion is +/- $530,000 and total cash invested is $120,000 + soft costs (debt service, fees, etc.) of perhaps $30,000 - $150,000 total
• Total investment is $150,000 debt + $530,000 debt = $680,000
• To support this structure the value would need to be around $816,000 or more (20% more than total costs).
• If this all happened as planned, and the property is sold, the seller makes $136,000 on a cash investment of $150,000 - a 90% return thanks to leverage (it would likely be less in actuality due to realtor fees and taxes, etc.)

That is how it used to work.  It is clear that this was probably too attractive and too easy.  Too much was built by too many people who were just trying to cash in on the boom - many investors bid up the prices of just about everything develop-able and the resulting end prices were too high - and the supply too large - to be sustainable.  

Yet now, with market prices down say 20% from highs (much more in some markets), the banks are generally unwilling to lend, and it doesn’t make sense to me for a few reasons.  First, banks don’t want to own property.  I get that. They don’t want to foreclose, selling property or finishing partially complete projects is not their business. Yet if you think back to the example above - and you change the numbers a bit to be less favorable for the developer, you can easily create a scenario where it is hard to imagine a bank losing in nearly any situation.  The bank could require more down and/or more of an equity cushion on the back end.  Let’s say their requirement changes so that you put 40% down and need 30% equity on the back end.  In the example given above that would mean putting $160,000 down and having to have total costs not exceed about $571,000 (on finished value of $816,000).  Would this eliminate many investors and developers from the market?  Sure it would.  Would it also almost eliminate all risk for the bank?  It really would.  

Assuming the lender were comfortable in the ability of the developer to complete the project so the bank wouldn’t get stuck with it, there is very little financial risk.  For the bank to get hurt the property would need to sell for $245,000 less than expected, and it would need to do so in markets that are already down 15-20%.   Could the developer lose money - you bet.  Could the bank? Nothing is impossible, but if you’re not comfortable with that little risk as a lender I’m not really convinced you’re a lender. 

Unfortunately many lenders won’t make these types of loans under any scenario.  That type of close-minded and formulaic approach to lending is exactly what got us in this mess in the first place (check this box, now that, ok, approved!).  I continue to believe that there are many deals that can and should be financed by lenders right now, and that their risk, because of market forces, would be far less than they used to be.  To be fair I know that many of their hands are tied by regulatory agencies, etc., but at the end of the day, lenders lend.  It’s what they do, or should.