Photo of Jamie Butler “It’s a pretty diverse field of capital sources for what is really a narrow field of opportunities:,” says Butler.

BETHESDA, MD—In the years following the Great Recession, banks represented the lion’s share of construction financing, typically providing loans for near-total construction costs at a relatively cheap rate of 2.50% on top of LIBOR. Now, amid changes in regulations, banks have tightened up on leverage—instead of 75% to 80%, leverage has dropped to about 65%–and developers are paying almost twice the previous interest rate due to rising spreads and increase to the LIBOR index.

The new, more conservative approach to bank financing has caused loans to become smaller and more expensive than before. This has brought a wide array of alternative lending sources into the construction financing arena. With that expanded compass of choices, borrowers also need increased levels of guidance in selecting the source, and solution, that best meets their needs. Jamie Butler, managing director of Walker & Dunlop, spoke with on navigating this new lending landscape. Across most sectors, we’ve seen a ramp-up in construction activity but at the same time we hear that there’s a pullback as far as lenders are concerned. Is there a disconnect between the lender’s viewpoint and commercial real estate fundamentals?

Jamie Butler: Rather than it being a disconnect, I think there’s been more of a massive shift on the commercial lending side that has occurred independently of commercial real estate fundamentals. That shift has been driven by regulation and by consolidation—of banks, especially. The amount of liquidity that’s required today of banks to make the same level of construction loans they were making just four or five years ago is a substantial barrier to increasing, or even maintaining, historical loan volumes. Bank consolidation has compounded the issue by reducing the amount of local and regional options for borrowers, especially in the construction lending space.

The fundamentals are still very strong, largely because we’ve had a very consistent real estate cycle for the past seven years. The landscape of commercial real estate in most markets is as strong as it’s ever been. The result is that a gap has developed between demand for construction in many markets and the  ability for traditional construction lending sources to keep pace.. As that gap has widened, we have seen a flood of alternative construction lending sources looking to meet the demand. These sources include debt funds, overseas banks, private equity and pension funds attracted to the risk adjusted returns of construction financing.

Over the past five years, this has become a much larger share of our lending market, and those lenders don’t have the same requirements and hurdles as traditional construction lenders. They’re largely unregulated, they largely control their own liquidity amounts, they’re not told what they have to hold on balance sheet and in most cases, they have a heritage in real estate. Many have an equity side to their business or they hold real estate themselves, so unlike a commercial bank, where their primary business is either retail banking or investment banking, the non-regulated lenders of today are well-versed in real estate. As a result, it makes for a good, user-friendly option for most of our borrowers. When banks do make loans, what are the underwriting criteria in which they’d be more conservative compared to a few years ago? Loan-to-value ratios obviously have gotten tighter.

Butler: Loan to value and loan to costs are always good metrics, and those have probably come down by about 10% over the past few years. In terms of the underwriting, though, the lenders are constantly aware of underwriting to an exit that increasingly is unknown. It was as unknown five years ago as it is today, but now, since we’ve been in such a low interest rate environment, most lenders are underwriting with more conviction to an exiting in a higher interest rate. This has a direct impact on proceeds via debt service coverage tests and exit cap rates. In the case of multifamily, the underwriting is somewhat easier, because you have entities that are providing debt more consistently, such as Fannie Mae and Freddie Mac. However, on the office, retail, and other commercial asset classes, there’s not as obvious a consistent source of takeout for the construction debt. It ebbs and flows with the CMBS market, life companies and so on. The result is a much more conservative sizing of these loans. Even as non-traditional lenders are more willing or more disposed to make construction loans, are they also becoming more conservative in their underwriting?

Butler: In some cases, they are. In some cases, they’re looking very much like a traditional bank lender. That’s happening in large part because more core capital—which is cheaper capital and likes to have safer money—is moving into that debt space. As a result, it’s not unusual to get quotes back from a bank, a debt fund, some private equity and some pension funds and have them look, at least on the margins, pretty similar to one another.

There are opportunistic lenders out there who are always looking for a much higher yield and therefore a higher risk. I don’t think they’re becoming more conservative; what’s happening is that there was not a very good middle tier of lender between a bank and an opportunistic fund. Now you’re starting to see that get filled up and starting to push much more toward the traditional bank execution in the economics than the opportunistic funds. Walker & Dunlop not only looks across a number of capital sources, but also considers a number of different potential solutions. How does this play out for clients?

Butler: By way of example, last year we closed loans with over 150 individual capital sources. That’s a wide spectrum, and includes local, regional and national banks, life companies, pension plans, international banks, private equity, debt funds. It’s a pretty diverse field of capital sources for what is really a narrow field of opportunities: construction loans, largely on multifamily but not exclusively. Our role is to really know every one of them, so we can be sure we are connecting them to the right opportunities on behalf of our clients.

By the same token, it also makes it more difficult than ever for an owner or borrower to have visibility to all of their options and understand which one is best for them. The variety is almost overwhelming. We’re able to synthesize down from that very large bucket of capital sources to the very best for their particular transaction.

We keep our pulse on that because these lenders, especially the alternative ones, do change course in terms of what they’re looking for both in economics and in product type from year to year and sometimes within a particular calendar year based on their investors demands. It’s our job to understand the direction and flow of that capital at all times. Is keeping your finger on the pulse more important now than ever?

Butler: Absolutely. I would venture to say that it’s not even the same game anymore as it was five years ago. There’s a much wider array of options, and so you need someone who is focused on that market every day to understand what the array is, and where a particular project falls within that spectrum.