The year 2017 may be the year of “Cash-In Refinancing”, with many properties not generating sufficient cash flow to attract new senior loans sufficient to pay off maturing loans. The “cash in” is the combination of fresh borrower equity (either with their own funds or a new partner’s) or with new senior debt in combination with “gap” financing either through mezzanine, bridge, hard money or preferred equity capital. Often the gap financing is covering a construction element to re-position the asset.
As I mentioned in my last blog, the concern about what is left in the wall of maturities is centered on a few asset types, and we are frequently being asked to do work on these sites in support of re-positioning. Some examples:
- Retail – there is the typical re-tenanting but in a lot of cases, significant alterations are being made to demise space to sizes that are more in line with market demand.
- Malls – we are seeing re-purposing of these assets which may include complete tear down and rebuilding or partial reconstruction in order to bring in other uses, for example turning a vacant anchor store into apartments.
- Office, particularly suburban – a lot of these loans in distress are in need of major renovation, not just cosmetic improvements but considerable upgrades to building systems that are past their useful life or are energy/water-inefficient. Again, a lot of times space has to be demised/re-purposed, particularly in cases where buildings lose large tenants and that market no longer supports large tenant users.
So on top of the challenge in weighing market risks and making an asset more desirable, there are some physical risks to consider that come along with rehab projects.
The risk in rehab
Construction is always risky, but with rehabs you may have some unexpected surprises. You never know what is behind that wall! Especially with an older building, there may have been undocumented renovations since the original build. Structural, electrical, and mechanical systems turn out to be different or not located where they are supposed to be. You may run into hazards like asbestos, mold, or lead paint.
Lenders may not fully appreciate how those surprises can change the course, schedule, and cost of a project. So what can you do to manage these risks? In short, don’t take shortcuts with your underwriting and administration of the loan.
Managing construction risks
A solid risk management program for a construction loan typically contains some or all of the following components, either from the lender’s internal team, a 3rd party, or some combination:
- Doc & Cost Review – Is the construction budget and schedule reasonable? Is there enough time and cost contingency built in for those unexpected surprises? An independent review of all the documentation by an expert with current and thorough industry knowledge will help confirm this.
- Contractor Evaluation – Can the contractor feasibly handle this project? Are you getting their A-team? Or are they over-committed at 6 projects when they are only really outfitted to handle 3 (and yours is the 6th project)? Asking important, specific questions or hiring an independent expert that knows how to evaluate the contractor will help ensure you get a good team in place.
- Construction Progress Monitoring / Monthly Inspections – Has the project progressed according to schedule? A monthly construction inspection will keep payments from getting ahead of the progress.
- Funds Control – Are the construction budgets still sufficient and are the progress payments making it to the proper subcontractors and suppliers? Do you know who the subcontractors and suppliers are that have lien rights on the project and are you obtaining proper lien releases? Having a construction funds control and disbursement program in place will help ensure that money is not diverted from the project and the right folks get paid.
It’ll be interesting to see how this year shakes out – just how many troubled assets are left, who has the appetite to take on these projects, what creative re-positioning strategies they’ll come up with, and what debt and equity vehicles will lead the way in re-positioning these assets. Seems like there’s a lot of opportunity for those that can manage the risks.
For those in the lending community that want a good forum for peer discussion on managing construction risk, I highly recommend the Construction Lenders Risk Management Roundtable, which is gearing up for its annual meeting in early March. Click here for more information or feel free to email me.