Acquisition costs - Purchase cost of the land
Soft costs - Architectural plans, building permits, etc.
Hard costs - Actual costs associated with the materials & physical labor.
Closing costs - Construction loan, title insurance, escrow, real estate taxes, & per diem interest.
Loan to cost ratio - Is used to calculate the percentage of a loan or the amount that a lender is willing to provide to finance a project based on the hard cost of the construction budget. After the construction has been completed, the entire project will have a new value. For this reason, the LTC ratio and the LTV ratio are used side by side in real estate construction. The maximum LTC for most construction projects is 80%.
Example: Assume that the hard construction cost of a construction project is $2,000,000. To insure that the borrower has some equity at stake in the project, the lender provides a $1,600,000 loan. This keeps the project slightly more balanced and encourages the borrower to see the project through. The LTC ratio on this project is 80%.
Loan to future value ratio - Compares the total loan provided for a project "against" the value of the project after completion. Assume that the future value of the project, once completed, is "double" the hard construction costs, i.e., $2,000,000.00 multiplied by 2 = $4,000,000.00. Therefore, if the total loan provided for the project is $3,200,000, the LTV ratio for this project is also 80%, i.e., $3,200,000.00 divided by $4,000,000.00 = 80%. The maximum LTV for most construction projects is 75%.
Interest reserves - Reserve account that will make the payments on the construction loan during construction.
Contingency reserves - Reserve account that will pay unexpected cost overruns.
- The Loan-to-Cost Ratio is “different” than the Loan-to-Value Ratio
- The Loan-to-Cost Ratio only considers what it actually costs to build the project.
A “borrower” owns a piece of land that would be an ideal site to build a new home, apartment building, office building, etc. The land alone is worth $1 million.
The borrower wants to build a new home, apartment building, office building, etc.
Including the $1 million value of their land, their contractor tells them that the total cost to build the proposed home, apartment building, office building, etc. will be $10 million aka “the budget”.
If the borrower owns the land free & clear, the borrower would only need $9 million more to build the new home, apartment building, office building, etc.
The borrower “could” go to a commercial lending institution offering construction loans, e.g., a bank, credit union, or mortgage company specializing in arranging construction loans, etc. and “request” / “apply for” a $9 million construction loan.
The construction lender would then compute the Loan-to-Cost Ratio. This is an underwriting function.
The loan amount would be $9 million, and the total cost would be $10 million, so the $9 million would be divided by the $10 million. Therefore, the Loan-to-Cost Ratio would be 90%.
Formula: $9,000,000 divided by $10,000,000 = 90% (LTC).
Is 90% loan-to-cost too high? Traditionally, construction lenders will only lend up to 80% of cost.
Additionally, if a property type is “out of favor” with investors at a “particular” point in time, e.g., assisted living facilities, hotels, & office buildings located in many over-built central business districts, some construction lenders might only want to go up to 70% loan-to-cost or possibly even lower, i.e., as low as 55% LTC.
However, loan-to-cost ratios are frequently “stretched”, i.e., increased.
If the borrower has a liquid worth of $10 million, and the borrower is willing to personally guarantee the loan, many construction lenders “might or would” be willing to make the loan at 90% loan-to-cost. This “arrangement” may also involve requiring the borrower to open a bank account with the lender. In such a case, there is frequently a significant deposit needed which would be held without any withdrawals permitted during the course of construction and then released after the construction was completed and the construction loan was paid in full.
If the borrower had developed similar property types in the past, in other words, they had a serious track record & a substantial experience with construction projects, an “aggressive” construction lender might even be willing to lend them up to 95% loan-to-cost.
What if a developer can't come up with 20% to 30% of the total cost of the project?
In that case, the developer will probably need to:
- either bring in a partner with more equity dollars
- obtain a “mezzanine” loan.
Mezzanine loans are similar to second mortgages, except a mezzanine loan is secured by the stock of the company that owns the property, as opposed to the real estate.
If the company (usually a LLC) fails to make the payments, the mezzanine lender can foreclose on the stock in a matter of a few weeks, as opposed to the 18 months it often takes to foreclose a mortgage in many states. The owner of the company that owns the property controls the property.
Foreclosing on a mortgage can take years, especially of bankruptcy is filed by the borrower. In contrast, a mezzanine loan is secured by the stock of a company, which is personal property and can be seized much faster.
Mezzanine loans are also large, i.e., generally greater than $2 million. It is occasionally possible to obtain mezzanine loans as small as $1 million.
In addition, mezzanine lenders typically want big projects. If the property you are trying to finance is not worth close to $10 million, you may have a hard time attracting the interest of any mezzanine lenders.
There are three typical uses for a mezzanine loan.
- The owner of a $10 million shopping center has a $5 million first mortgage from a conduit. The owner wants to pull out some equity, but he cannot simply refinance the shopping center because the first mortgage has either a lock-out clause or a huge defeasance prepayment penalty. In this instance, he could probably obtain a $2.5 million mezzanine loan to free up some cash.
- An experienced office building investor wanted to buy a partially-vacant office building in a fine location. Once again, assume that the purchase price is $10 million (when the office building is still partially-vacant) and that the conduit first mortgage is $5 million. This may surprise you, but the right mezzanine lender might be willing to lend a whopping $4 million! But isn't that 90% loan-to-value? Yes, but when the vacant space is rented - remember, our buyer is a pro - the property will increase to $12 million in value. Suddenly the mezzanine lender is back to 75% loan-to-value and his rationale is obvious. This kind of deal is called a value-added
- New construction. Example: A developer wanted to build a 400-room hotel across the street from Disneyland. Hotels today are out of favor, and a commercial construction lender might only be willing to make a loan of 60% loan-to-cost. If the total cost was $20 million, the developer would ordinarily have to come up with 40% of $20 million or $8 million.
A $3 million mezzanine loan solves the developer's problem.
The commercial construction lender would advance $12 million, the mezzanine lender would make a $3 million mezzanine loan, and the developer would "only" have to come up with $5 million.