Commercial Investment Real Estate

MAR-APR 2015

Commercial Investment Real Estate is the magazine of the CCIM Institute, the leading provider of commercial real estate education. CIRE covers market trends, current developments, and business strategies within the commercial real estate field.

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14 March | April | 2015 Commercial Investment Real Estate FINAN CIN G FO CUS Hans Hansen/Thinkstock a As the economy recovers from the Great Recession, construction lending is slowly resuming its place as an important component of real estate lending. For example, in Chicago, there has been a fl urry of multifamily developments, and currently two major offi ce projects are under way. And in secondary markets such as Cleveland and Kansas City, entrepreneurial developers are undertaking challenging adaptive reuses by converting vintage offi ce buildings into hotels and condominiums. Clearly construction has returned and with it, the construction loan. Apart from the many nuances of the dif- ferent product types, a construction loan is unique because the loan is for something that does not yet exist. T e developer must create a cogent business plan that will withstand a lender's underwriting. T e lender must negotiate big-picture loan terms with the borrower and underwrite the feasibility of the ultimate project and its economic value. By the time a loan closes, the lender and the developer have typically f nalized many critical-path items including an agreed-upon budget. The loan agreement will require post-closing lender approvals for anything not f nal at closing. T erefore, if the basic plans of the project are in place but key items such as f nish standards are not f nal- ized, lender approval must be required as a funding condition. Other funding hurdles, such as orderly draw requests with lien waiv- ers and architect's sign-of s, help the lender control the process. Notwithstanding its approval rights, a lender is contractually obligated to fund the loan provided the borrower is in compli- ance with the loan agreement conditions. Recently, a California jury reached a $39 million verdict against East West Bank, f nding the bank breached its construction loan agreement. T at action forced the fam- ily-owned developer to default on the loan, which eventually led to foreclosure. Change Orders Change orders are part of the construction process, and they occur for a number of rea- sons, including overly aggressive contractor bids, inef ciencies in design/build projects, material cost increases, cost estimates that prove to be wrong, and developer or end- user requested changes. Change orders usually mean increased costs and the risk that the project could go over budget. Change orders may also reduce the costs of the project through value engi- neering with either seen — the lobby or pool build-out — or unseen — the heating and air conditioning system — changes. Loan-in-Balance Provisions T e ultimate protection for a lender is the requirement that the loan remain "in bal- ance," meaning that the unfunded loan is suf cient to complete the project. T e budget expresses the project's cost. It accounts for everything required to transi- tion from concept to f nished project, includ- ing leasing costs and operating def cits for multifamily projects; marketing costs for condominium projects; tenant improvement costs and leasing commissions for of ce proj- ects; and furniture, f xtures, and equipment costs for hotel developments. To the extent that change orders increase the overall cost, reallocating savings from other line items or contingencies provides the Seeking Balance Construction loans present unique circumstances for lenders. by Joel C. Solomon

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