Development and Construction Financing

1
Chapter 9

• Development and Construction Financing

2
Land Loans

• Someone buys, or obtains the option to buy, a
  tract of raw (unimproved) acreage
• Raw acreages development potential is untested
  lenders are wary
• Individuals who spot a parcels development
  potential and begin chain of events leading to
  productive use often not developers themselves
• Person who carries the land until it is ready for
  development will often seek long-term mortgage
  financing

3
Seller Financing

• Institutional lenders reluctance to advance
  funds on raw land, and their imposition of low
  loan-to-value ratios and short loan periods,
  spawned financing by sellers of land
• Benefits of seller financing
• May include lower interest rates
• More extended loan periods
• Front-end fees may be lower or absent

4
Partial Release Provisions

• Lien of a land loan mortgage may cover several
  separate parcels or a single large parcel that is
  subsequently subdivided often repaid in
  installments, and parcels are released from the
  lien as they are sold or developed and refinanced
• Mortgage covering several parcels and containing
  release clauses often referred to as blanket
  mortgage
• Developers needs to dispose of parcels and
  generate additional cash often conflict with
  lenders wishes to maintain sufficient collateral
  to secure the remaining balance of land loans

5
Purchase Money Mortgage

• Seller conveys title and the buyer simultaneously
  delivers a mortgage to secure the note given in
  part payment for the land (also called take-back
  mortgage)
• If recorded simultaneously with the deed, it
  becomes a lien on the property senior to any lien
  the buyer might create
• May create problems for developers unless sellers
  agree to subordinate the liens to financing that
  is to be acquired later from institutional
  lenders accomplished by subordination agreement
  in mortgage itself

6
Installment Land Contract

• Seller financing alternate to using mortgage
  seller retains title, and sometimes, possession
  and use of land
• Requires periodic payments of principal and
  interest to amortize the purchase price over the
  contract period at which time the seller
  transfers ownership of the property to the buyer
• May become extremely complex purchasers may be
  given the right to acquire title to successive
  parcels in a series of transactions that might
  extend over many years

7
Options as Financing Technique

• Options serve as a substitute for the financing
  that would otherwise be needed to warehouse land
• Enhance flexibility and permit reservation of
  choice sites with minimum front-end cost may be
  expensive
• Range from simple to elaborate
• Declining credit options permit progressively
  smaller portions of the option price to be
  counted toward the purchase, as the option period
  grows
• Rolling options permit the optionee to add
  specified new parcels to the option contract as
  parcels already included in it are acquired
• Use of option postpones the interest cost of
  financing limits developers potential loss

8
Land Development Loans

• Intermediate step in the overall development
  process typically includes
• Grading the land
• Obtaining zoning (or rezoning)
• Installing various utilities
• Constructing sewers, drains, gutters
• Constructing streets

9
Table 9.1
10
Construction and Development Loans

• Generally treated like commercial loans, secured
  by the credit rating of the borrower as well as
  by the real estate
• Complex documentation
• Time-consuming loan administration
• Most profitable area of real estate finance
• Intended to be outstanding only during the period
  of construction

11
Construction Lenders Primary Concerns

• Will the borrower complete the project in
  accordance with the plans and specifications, on
  time, and at the budgeted cost?
• Will sufficient funds be available to retire the
  construction loan when the project is completed?

12
How Construction Lenders Control Risk

• Carefully evaluate builders and subcontractors
  experience and financial responsibility
• Analyze income and expense projections for the
  completed project and draw conclusions about the
  projects feasibility
• Construction financing may not be available
  without a firm commitment from another competent
  lender to provide long-term financing when
  construction is completed (takeout or end loan
  commitments)

13
How Construction Lenders Control Risk (continued)

• Loans are typically disbursed in stages as
  construction progresses. Payments (called draws
  or progress payments) are usually made to the
  developer, either directly or indirectly though
  the title insurer, on completion of various
  stages of construction
• Lenders require that applications for advances be
  accompanied by the itemized listing of the work
  completed, along with evidence that construction
  costs have been paid

14
How Construction Lenders Control Risk (continued)

• Lenders may also require certification that
  completed work conforms to plans and
  specifications and satisfies all government
  regulations
• Alternative loan disbursement approach is to make
  payments directly to suppliers, contractors, and
  subcontractors on receipt of invoices and payment
  instructions form the borrower (called voucher
  plan)

15
How Construction Lenders Control Risk (continued)

• Before funding final advance, construction lender
  requires evidence that all improvements have been
  completed in accordance with the plans and
  specifications and that appropriate government
  authorities have approved the premises for
  occupancy

16
Cost of Construction Funds

• Construction loan interest is higher than that
  for long-term mortgage loans, reflecting the
  greater risk and higher administrative costs
• A borrowers actual cost is usually considerably
  above the interest rate stipulated in the loan
  documents the effective cost is influenced by
  factors such as loan fees and the average
  principal amount outstanding over the loan
  period, as well as the contract interest rate

17
Managing Interest Rate During Construction

• Lenders rarely specify fixed interest rates for
  construction loans
• Rates are generally indexed to some criterion
  such as the lenders prime rate, or the London
  Interbank Offered Rate (LIBOR)
• Developers may negotiate interest rate cap a
  maximum above which the floating rate loan ceases
  to float
• Large-scale developers may engage in interest
  rate swaps to gain protection against interest
  rate increases during construction
• Developer may take hedge position by taking a
  position in an interest rate futures contract