We will usually get 1 or 2 projects a day from sponsors or brokers asking whether we can get their construction projects financed. We usually subject the project to a quick quantitative analysis to determine whether we should pursue financing for a project. This allows us to filter based on objective measures rather than subjective feel. I have fallen in love with a number of proposed developments only to find out that they were not economically feasible after running the numbers. I hope this helps both developers and brokers come to realistic conclusions regarding the financing of their projects. It’s not that their projects can’t be financed. It just may take an adjustment to the overall capital stack to get it done. For instance, a mezzanine loan may be needed to fill a portion; or maybe an equity partner can help increase the equity portion of the stack; or, maybe both are needed to complete the financing stack. So here is the quick primer.
Commercial construction loans are usually underwritten using 6 financial ratios. Every lender has its own parameters for each ratio, and each loan will probably not necessarily meet each parameter for a lender. This is where a lender’s judgment comes into play as well as the relationship that the lender has with the borrower or broker. The relationship (if good) can possibly sway the lender to take a chance if the business plan is solid.
The loan-to-cost ratio is the construction loan amount divided by the total cost of the project. This ratio typically should not exceed 80%. In other words, the developer is responsible for contributing at least 20% of the total cost of the project – usually in the form of free-and-clear and entitled land, with most of the architectural and engineering costs prepaid for by the developer. Plan for the lender to quote at 70% to 75% LTC. This means that the developer must cover 25% to 30% of the total cost of the project.
The loan-to-value ratio on a commercial construction loan request is computed by taking the construction loan amount and dividing it by the value of the commercial property, when it is completed and fully-leased. The loan-to-value ratio on a commercial construction loan request should not exceed around 70%. This provides some cushion for the sponsor to refinance the property to pay off the construction loan.
The debt service coverage ratio is the property’s Net Operating Income (NOI), upon completion and leasing, divided by the annual debt service (P&I payments) on the proposed takeout loan. A takeout loan is just a permanent loan used to pay off a construction loan. This ratio should exceed 1.25.
The profit ratio is the difference between the fair market value of the property, upon completion and leasing, and the total cost of the project, all divided by the total cost of the project. Measures the potential profit for the developer for building the asset. The developer could be tempted to walk away if the project becomes a headache for him or her without a huge incentive on the back-end. The profit ratio should exceed 20% to 22%.
The net-worth-to-loan-size ratio. The developer’s net worth should be at least as large as the construction loan he is requesting. This ratio needs to be at least 1.0. There is no hard and fast rule on this ratio as to whether the loan request will be turned down. The lender (bank or private) will most likely use it to either resize the loan request, or adjust other parameters to reduce its risk.
The debt yield ratio is computed by taking the property’s net operating income (NOI) and dividing it by the construction loan amount. 8.5% to 9% is probably the minimum. This is the lender’s expected return if it had to take back the property.
The bottom-line? Run the numbers.