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February 22, 2001

Financing in an uncertain economy

  • Despite more stringent controls and recent fluctuations within the marketplace, capital is still available, but it is far more selective.
    • By CHRIS AGGERHOLM
    Bentall Corp.

    Seattle’s economic boom has fueled major development, with new projects being announced frequently and a smattering of tower cranes marking “work in progress.” Property values are at historical highs and construction costs are ever increasing.

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    Seattle is still enjoying a period of major development, but the uncertain economy is restricting the availability of capital for all but the surest projects and strongest borrowers.

    With current economic uncertainty, how will the next round of development get financed?

    Development is a business that by definition must continue to build in order to remain viable. Successful development requires actively, yet selectively, seeking new opportunities and having the necessary financial strength to develop projects that have long-term financial feasibility.

    To increase returns and manage capital as efficiently as possible, developers and investors use leverage. Before beginning a development or purchasing a property, the overall economics must be understood, and debt considerations including availability, costs and terms such as preleasing thresholds must be addressed. Together, they need to be modeled into conservative underwriting assumptions that will be acceptable to lenders.

    Debt also affects the exit strategy, defining how much equity will remain in a project, or be required by an investor. The viability of financing and the associated costs will affect a project’s returns and marketability once it’s completed.

    Capital availability and terms have changed dramatically from the lenient 1980s, which proved disastrous, to today’s more conservative lending environment. Developers and lenders are faced with wild swings in the 10-year Treasury, FDIC watch lists, rapid technology-related growth and contraction, and large forecasted supply increases competing against several hundred thousand available square feet generated by downsizing or failed companies.

    Despite more stringent controls and recent fluctuations within the marketplace, capital is still available, but it is far more selective. With a seemingly endless supply of projects and borrowers to choose from across the country, lenders can afford to team with the most viable projects and the strongest borrowers. Local projects vie for capital on a regional and national basis, which quickly forces marginal projects onto the sidelines.

    The relatively few lenders within the marketplace that fund large construction projects enhance competition for available capital.

    Several development projects in this area have been affected by the more conservative terms for capital availability, causing speculation as to whether they will be completed, at least under their current ownership structure. Another significant question is whether preleased tenants will be in place when a project is completed.

    In order to reduce risk and diversify capital, it is commonplace for many large loans to be syndicated — a process where a lead bank lays off portions of the loan to a group of lenders. This can cause complications and increase costs for the developer who has to deal with several lenders and their individual requirements.

    Some developers will limit these issues and potentially decrease costs by forming a syndication that comprises lenders with whom they have established relationships. Historical performance on the part of the developer is not necessarily a guarantee, but it can reduce the lender’s risk and create a better working relationship.

    Preleasing thresholds continue to represent a major component of a construction loan’s terms. Banks typically require that a project attain some amount of preleasing prior to funding a loan, reducing the lender’s risk by helping to assure the project’s financial success. As an example, a typical requirement might be that 20 percent of the project’s overall square footage be leased prior to construction loan funding.

    Prelease commitments are only as valuable and financeable as the quality of the tenant, as illustrated by the recent “dot-com shakeout,” in which a number of companies that preleased new projects fell upon financial hard times, leading them to reduce or terminate these commitments well before construction completion.

    Other projects have experienced situations where, in an effort to attain prelease thresholds, leases were executed with noncredit tenants including terms or occupancy levels that had to be renegotiated to meet lender or partner requirements.

    The preleasing requirement is a Catch 22 for the developer in need of construction financing, as it is difficult to obtain a tenant’s commitment two to three years prior to a project’s completion.

    In order to pull ahead of competing projects and show commitment, developers may begin a project prior to securing financing. This requires that a tremendous amount of equity be spent without the assurance that financing will ultimately be available. A developer must effectively be capable of building a project for cash if it is started on speculation.

    Lenders are addressing tenant credit and security issues by implementing significant control measures involving approval of prospective tenants and their leases. As an example, lenders may require that prospective tenants have achieved positive cash flow, or require the lender’s approval if they have not.

    Once a project is completed and leased at today’s inflated rental rates, developers are faced with the relatively new phenomenon of finding permanent financing for a project with historically high values per square foot.

    Traditional financing sources become significantly differentiated when lending against these valuations, most likely resulting in the need for a large amount of developer equity to remain in a project, or be required by an investor in the case of acquisition.

    Real estate is a cyclical business. The boom and collapse of the ‘80s and early ‘90s has faded and real estate has reached new highs over the last few years. Demand has outstripped supply, presenting the need for new development — the question is how much?

    Competition for limited capital sources will continue to demand historical performance, financial strength and an understanding and incorporation of its terms into project underwriting and marketing programs.

    In order to remain successful across this cycle it is necessary to selectively pursue new opportunities, which are funded in part through careful capital management, including the fracturing and reinvestment of capital from mature assets.

    Chris Aggerholm is regional acquisitions manager for Bentall Corp. He is responsible for the sourcing and analysis of Bentall’s development projects.


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