Construction Finance: Is the Drought Over?

Thanks in part to a decision made last summer, businesses that want a new home, or would like to expand their existing facilities, will find the financing waters smoother than they might have expected, according to bankers and executives who have gone through the construction financing process. The underlying reason is the Federal Reserve's announcement last July that it intends to keep interest rates low until 2013.

"That's really the first time in my 27 years in the banking business that the Fed came out with a statement that said anything beyond the short term," stated Todd Cegelski, a vice president at Johnson Bank. "When the Fed signaled that, banks became willing to lend at longer terms with lower interest rates. To me, that was the start of things loosening up."


Better shop around

Just how loose probably is in the eye of the beholder. While Cegelski agrees that financing terms are more favorable, he said it will depend on the size and scope of a project, and the location, especially in Dane County. His one caveat is that expansion-minded CEOs will have to do some comparison shopping. "Some banks are much more aggressive than others at this point," he noted.

In addition, Cegelski doesn't see much reliance on equity based on appraisal, so borrowers will have to put more of their own cash into the deal. "At least in the foreseeable future, you will see that requirement," he predicted. "It also depends on the financial institution you are working with, and your history with that lender. We've heard about a lot of different proposals being made, and some are much more aggressive than others, but I've not heard of anyone doing 100% loan-to-cost financing at this point. In the short-term new world, borrowers are going to have to come to the table with some cash. Whether the requirement is 10% or 15% or 20% will depend on the individual institution and other conditions specific to the deal."

Ed Kinney, senior vice president of Settlers Bank, agreed that the days of 10% cash down and a friendly appraiser are gone. "Banks and bank regulators want to see investment on the part of the owner, and rightfully so," Kinney said. "A few years back, we started to see a lot of 85% financing on income properties. I do not think we will go back to those terms anytime soon, if ever. In fact, given that banks are overweight on real estate, many banks are not looking at real estate lending opportunities over 70% loan-to-value.

"The prevailing terms reduce return on investment for the equity holders, but also reduce risk for everyone involved in the transaction. But at the same time, property values have been driven down from their peaks, so there are some tremendous opportunities out there for investors with cash and a good bank relationship."

In some cases, financing depends more on the lender's appetite for risk than the merits of the borrower. "Yes, however it will also depend on the relationship," Cegelski said. "If the borrower has a long relationship with the existing bank, and they are going to continue to support them, they may have a more
favorable outcome than if they are seeking financing from a new source."

According to Cegelski, the largest component of the underwriting decision is going to be the borrower's operating cash flow. If the borrower has not had a strong financial performance over the past two or three years, but believes that by expanding he or she can get better results, "it's going to be a much tougher road than if they produced strong financial results now," he stated. "If a company can support the new debt load at its current cash flow before expanding, it's a much easier deal."

Without a good cash-flow situation, nothing else matters. "In the case of owner-occupied properties, cash flow from the operating company is the primary source of repayment," Cegelski noted. "If you can't get past the cash-flow test, I don't believe that in today's environment anything else is going to matter. Secondary factors like loan-to-cost, loan-to-value, and using guaranty programs to reduce risk might help, but without the ability to service payments of the new project, it will be tough to get a deal done."

Kinney said banks need to balance their asset mix, which impacts their decisions. "It's true that banks that are very overweight, or have problems in certain sectors, may pass on lending opportunities, or have more stringent down-payment and underwriting requirements," he said. "Banks that have been burned in certain sectors may avoid them entirely. The classic current example is the hotel-motel industry. If you sense that your bank is down on your industry in general, it's time to look around."

Roughly the same analysis applies to expanding an existing building. Lenders will look at where borrowers are today, plus the cost of expansion, and then restructure the total debt. "The purpose of most expansions is to increase revenue and, at the end of the day, profitability," Cegelski noted. "We weigh all this, and the people who have a better chance of success are those who can cash flow the debt or have a realistic opportunity to generate a large increase in revenue, but if they don't, that's going to be a real stretch.

"The only thing I can say that might be different with an expansion, depending on the existing equity in the property, is there may be a lower requirement for cash in the deal. In this case, I think there would be more reliance on current appraised value."

If the situation isn't ideal for banks, there are ways around it. Government programs of the Small Business Administration, Community Development Block Grants, or New Market Tax Credits could bring more flexible terms. Favorable financing terms include longer amortization, lower cash-injection requirements, and longer-term fixed rates.

Kinney said SBA 504 financing is attractive for owner-occupied commercial real estate. "It can help a business to preserve liquidity by reducing cash outlays on a construction project to 10% to 20%, thereby retaining capital to support business needs," he said. "This program also allows a business to lock in very attractive 20-year interest rates on 30% to 40% of its project. It is available for equipment financing as well with attractive 10-year fixed rates."

With this type of owner-occupied commercial real estate, deals typically are structured with multiple lenders, but size plays a role here, too. "Typically what happens, unless the project is very large, is you have one primary lender," Cegelski noted. "The lender may choose to work with some agencies to provide Small Business Administration financing in the owner-occupied scenario, or there are different government programs, depending on the location of the project or the collateral required.

The lender should work with the borrower to explore those options when needed, including the addition of a co-lender for very large deals, Cegelski noted.

In terms of the cost of construction materials – steel, wood, drywall, and fuel – Cegelski said commodity prices are higher than most borrowers believe. To him, that's counterintuitive. "You'd think that because the economy is down, you'd get some good deals and to a degree you can," he said. "You might save more on labor cost as contractors are looking to keep their people busy, but commodity prices are what they are."

Loan Weaver

Mark Weaver, president of Weaver Auto Parts in Sauk City, financed a 30,000-square-foot expansion to the distribution center that serves 17 Weaver Auto Parts stores in south central Wisconsin.

Due to the size of the project, Weaver was encouraged to use the SBA 504 loan program and was pleased by the terms, especially after financing the construction of existing auto parts stores in more traditional ways.

"We have a good relationship with our banks, but I was surprised that it was as open as it was, pleasantly surprised," he said.

Weaver took out two SBA 504s, one with Settlers Bank, which did the real estate piece, and one with BMO Harris, which handled the equipment and fixtures. In terms of cash in the deal, the business was in "the 25% range" on both loans, which did not strike Weaver as an undue burden.

On SBA 504 loans, his advice for businesses that don't have a good relationship with their banks is threefold. First, have a well-thought-out and written business plan for this specific purpose. Second, 504 loans require more patience because prospective borrowers are expected to spend more time in meetings and provide more detailed financial and planning information. Third, it's important to work with a bank that commonly does the 504s because "it's a little more involved."

The real benefit of such loans, he noted, is the length of the lock on the term and the interest rate, which was below 5%. The bank picks up 50% of the cost, the SBA picks up the other 50%, and the SBA portion is locked for the term. "The equipment piece is locked for 10 years, and the real estate piece is locked for 20 years, so it's a huge advantage to do this," Weaver stated. "It was worth the extra meetings and information."

Due in part to the scope of the operation, Weaver was able to invest in alternative energy, installing a photovoltaic electricity system that generates 20% of the electricity, and heating and cooling the building with a new geothermal system. Asked if he has noticed a significant reduction in energy costs, Weaver said it's a bit like comparing apples to oranges, but he's pleased with the results. "If you do the ratios, it's very economical to heat and cool the building," he said, "and the working conditions are outstanding."

To accommodate single-stream recycling, Pellitteri Waste Systems took out a loan to build a 55,000-sq.-ft. warehouse addition to its existing material recovery and transfer facility. In a single-stream recycling facility, recyclable material is sorted down into clean, marketable commodities, a process that helps divert materials out of landfills.

Vice President David Pellitteri said the expansion will house a single-stream recycling line that will add 15 to 20 jobs to the Madison market, but the real challenge was convincing banks of its viability. That had to be done with the economy stalled out, but management was able to set out on a path to create savings, improve cash flow, and improve its financials to demonstrate to banks an ability to manage the business.

"With a banking system facing increased regulation and tight credit limits, we needed to find a way to promote our idea as a successful venture to lend on," he noted. "This required some reflection on ourselves and the existing business. We needed to control spending and limit expansion in order to improve cash flows and put money away for our down payment."

The next step was to find available funding sources. Many banks would not even look at the project, but two local banks were interested because of Pellitteri's desire to work with the SBA, which reduced some of the bank's exposure. "The lower interest rates and the ability to lock a portion of the loan for an extended period was a major draw for us," Pellitteri said.

The front-end work to solidify financials was augmented by a long-term contract with the city of Madison, but the appraisal came in significantly lower than the cost to build. This required additional upfront cash to maintain a 20% equity position. "This conservatism has killed many proposed deals, and at least delayed many dreams to happen," Pellitteri stated.

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