The rising interest rate environment in the past few years created significant challenges in construction financing regarding interest reserve and the ability to convert to term loans. For companies that have a commercial real estate loan in place and are having struggles, it’s important to give full disclosure of the situation to the banker.
“Acknowledge the problem and work with the banker on potential solutions,” says Suzanne Hamilton, SVP Commercial Real Estate Lending, ERIEBANK. “Borrowers who take that approach will find their banker is much more inclined and able to try to work through it with them. However, those who do not communicate because they’re afraid of the possible outcome are creating a potential worst-case scenario.”
Smart Business spoke with Hamilton about the state of construction lending and the solutions for those who encounter issues with their debt.
What is the situation construction companies are facing with borrowing?
The increase in the prime rate has driven up the interest rate for commercial real estate loans, which has proved challenging for construction projects. Banks that lend in this sector have a reserve that’s used to fund the monthly debt service of construction projects because a project under construction does not immediately have cash flow. Those reserves are quickly used up, so borrowers must come up with either additional equity or restructure their debt. But recently as the time has come for project owners to transition to a longer-term loan, many have not had the cash flow to support that permanent debt because the interest rates have gone up 2.5 to 3 percent higher than expected when the bank originally underwrote the project. And if the cash flow doesn’t support some minimum hurdles, the owner of the project no longer qualifies to convert to term loan at the bank or get the bank paid off with a perm loan provider. As a result, the borrower could be required to come in with a principal pay down, which is a challenge as the equity that they estimated didn’t materialize because the interest rates compressed the value and the cash flow.
How can borrowers address these challenges?
To help offset these challenges, some banks will work with the project owner to get them to a place of recovery or work to sell the property to another borrower to avoid a foreclosure situation. The latter may be unavoidable.
Community banks try to identify a solution, even those that might take some time, and work with the developers or project owners to figure out short-term fixes when it’s clear that success is near. In some cases, all that’s needed is time, so a community bank is willing to be patient and extend loans or try to work with them to find additional cash or support the debt in different ways. If they don’t have the liquidity to do that, a bank might work with them to sell the property to another borrower, and then the bank will finance the new borrower to both help the bank and the original borrower get out of the situation.
Unfortunately, another outcome is going into foreclosure. That’s been seen in Cleveland — several construction projects recently have gone into foreclosure as has been reported in the new cycle. The borrowers end up having to just walk away because there’s nothing they can do to support the cash flow and the debt.
Why is it important to keep a lender informed?
Commercial real estate development businesses borrow money routinely, and banks understand that. It’s up to their financial partner to analyze the project and advise them on the appropriate amount of debt that they should hold based on the project cash flow. That requires a two-way conversation. If there’s no feeling of partnership because a borrower becomes absent when issues arise, then the borrower is leaving it up to the bank to figure out what the legal solutions are to resolve the debt of an existing project because there’s no other path forward.
It is always important for borrowers to keep their partner bank informed, especially in problem situations, so that solutions can be determined ahead of any potential problems. ●
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