Falling interest rates may have a positive impact on the construction finance industry, said Jonathan Lee, principal/managing director of George Smith Partners, as banks show more willingness to lend. Lee recently spoke with Loretta Clodfelter, editor of Institutional Real Estate Americas, about the latest construction trends.
The FOMC recently lowered the target federal funds rate. What impact might that have on construction finance, and on the broader construction industry?
This is a positive development on multiple fronts for the construction industry. In the last 12 months, the debt side lenders have continued to get more conservative by constraining their advance rates with debt coverage tests on exit NOI. It becomes more difficult for them to push exit underwriting rates as a precaution when the treasuries are dropping precipitously. From the perspective of debt, I foresee leverage holding firm.
For projects needing JV equity, we have been seeing a lot of push back in the last 12 to 18 months on exit cap rates from equity sources. The chief complaint was that in a rising interest rate environment cap rates would by necessity also rise, thereby diminishing IRR. Now that rates have dropped, the pressure to raise exit cap rates has cooled, and more projects are hitting the 100–150 basis point delta equity seeks to achieve when comparing return on cost to the exit cap.
How has the real estate construction financing landscape changed in the past few years?
Largely, it hasn’t. Construction liquidity remains abundant on the debt, pref equity and JV equity fronts for projects that were either purchased at an opportune time or gained value through entitlements. The focus now is on the general contractor’s ability to actually deliver on costs and the strength of the backing on their GMAX contract. Increased scrutiny has been given to control by general contractors over their subs, as well as micro-markets where oversupply might cause hesitation. If anything, we are seeing a more robust push into markets from banks that candidly had a redline drawn around them only five years ago.
What are the construction trends an investor should be concerned about? Material costs? Labor shortages? Overbuilding?
The construction industry has done a tremendous job of self-regulating when it comes to oversupply and underwriting. I’m convinced the credit and subsequent leverage given in the last cycle will not be repeated. Despite the trade war, the flux in material costs has been largely manageable. The risk right now is in the availability of labor, with an emphasis on experienced craftsmen. Too many trades are stretched over several projects, and delays are occurring. But what we are also seeing is experienced crews in smaller projects being lured into higher-end projects for better wages. This has caused a quality issue in some aspects of smaller projects, which further delays them and increases costs as work needs to be redone. But when compared to the recession, where lack of construction financing, bankrupt sub-contractors and skittish JV equity littered the landscape, our feeling is that clients are thrilled to contend with today’s issues when compared to those of 2010.
