Debt Funds Enter Construction Lending Market

Debt funds are becoming more aggressive in the construction and land financing market. The regulatory environment has tempered bank lending on construction and land acquisition deals, and it has created an opportunity for debt funds to offer a high-leverage lending options on deals more than $30 million.

“The proliferation of debt fund capital and the desire to get higher yields is making those funds look for different and creative ways to carve out a niche and do some volume,” Shlomi Ronen, CEO of Dekel Capital. “Because the banks aren’t lending in that market, there has been a void. That has enabled the debt funds to come in and compete.”

This hasn’t always been the case. In the years leading up to the recession, banks would lend very high leverage on construction and land acquisition deals—up to 80% in some cases. Post-recession regulations have prohibited banks from lending at those ratios, but that has also left some developers without financing options for quality projects, according to Ronen. “Pre-crash, the banks were very active going to 75% to 80% of cost,” he says. “It varies market to market, but this cycle, generally, banks have not been that aggressive. If someone is looking for non-recourse, that usually puts the banks out. While banks generally have cheaper capital to lend, however, it has been very limited.”

Ronen stresses that these aren’t high-risk deals banks are turning away, but rather, they are large deals. “These aren’t bad deals that banks are turning down. Instead, the banks, especially the larger banks, are stratified,” he explains. “If it is a loan up to $30 million, you are probably still doing that with a bank. The larger loans over $30 million, banks don’t have the capacity. For those loans, the banks have been very conservative.” Debt funds will push up to 80% leverage, but borrowers should also expect to pay premium rates. Ronen says debt fund rates range from 7% to 8% at the high end.

For borrowers in need of high leverage, the cost makes sense. Ronen has clients that elect to go the debt fund route and others that would rather work with the lower leverage offered by the bank. “We are working on a deal in Central L.A. with a debt fund, and we are working on another deal in Koreatown where we had a debt fund interest, but the sponsor elected to take lower leverage with a bank,” he says. “In that case, we are structuring the deal with preferred equity that is going to sit behind the bank to get them up to the desired leverage, which is 65% to 70% of cost.”

This is a new space for debt funds, but it is growing quickly. “More of them are setting up to be able to do construction lending,” says Ronen. “It requires a different oversight and slightly different processes to do construction lending, and we are setting up to do so.”