5 things to know before getting construction loan

NATIONAL REPORT – Construction financing has always been a tough bucket of capital to access. In fact, securing financing for a ground-up, new-build project is one of the hardest asks in the hospitality financing world.

There are many factors influencing this situation. Generally speaking, banks have been more muted on hospitality projects. So, a larger share of deals is being executed by debt funds. In turn, this has led to an increase in the cost of capital and greater pressure for a return on investments.

However, these added layers of difficulty shouldn’t completely deter developers – there is capital out there, but like many things, it’s more expensive in 2024.

Construction costs have elevated significantly and more sharply than costs in other industries over the past five years. Interest rates are starting to decrease, but they’re still high. We have also seen some pullback when it comes to leverage. It used to be that lenders were looking for 70% to 75% leverage, but today, it’s more like 60% to 65%. Together, this all means that hotel developers are having to raise more equity, get investors to write bigger checks, and bring less debt into these deals.

Hospitality developers need to be able to consider all their options and weigh the possible pros and cons of their planned approach before going out for a construction loan. If you’re looking to secure funding for an upcoming project, here are some details to keep in mind.

1. Calculate your interest reserves carefully, then leave some extra leeway

Interest reserves play a critical role in construction loans, and developers should budget conservatively to ensure those reserves are large enough to mitigate any extra costs caused by delays and unexpected expenses. If reserves run out early, a developer may need to secure additional equity, raising overall project costs. Lenders rarely offer extra funds to cover these overruns. So, the developer will have to cut those extra checks.

There are a few ways to calculate interest reserves, but the two main methods lenders use are estimated and draw schedule.

An estimated approach, which is common in construction financing, uses a blanket advance rate to project interest costs.

A draw schedule, on the other hand, requires a general contractor to outline the entire budget, as well as a development timeline, specifying the monthly cash needs for the project. This can be a more accurate calculation of how interest reserves will likely be used based on actual cash flow, but it still doesn’t account for possible issues and delays. This is why having a padded interest reserve is so critical.

2. Hotels typically require a ramp up period – structure your loan accordingly

While some properties open to high and sustained occupancy level, it may take between one and two years for a hotel to stabilize and start bringing in reliable revenue. There are ways to structure loans that accommodates this ramp up period.

For example, some loans are built in two parts – construction and post-opening. During the construction phase, borrowers are typically paying more interest than principal (another reason one might need padded interest reserves!) and then the moment you open the property, the loan becomes amortizing.

For properties that take a year or two to ramp up, developers might face a debt service shortfall in the first year. To prepare for this, they should consider including some interest carry in their loan proceeds.

For example, if debt service for a construction loan in year one is a million dollars, a developer might allocate an additional half a million dollars to help offset cash flow from operations.

3. Be aware of hidden costs and fees

Origination points, exit fees, and prepayment penalties are all par for the course when it comes to construction loans. It is incumbent on the developer to seek out the specific details of these fees. For example, origination fees are commonly 1% of the total loan amount. For a $1 million loan, that’s $10,000 due at closing.

Another common fee is an exit fee. Many, many construction loans are refinanced, and exit fees must be considered during that process as well. A lot of developers don’t necessarily model that into their loan plan and are caught flat-footed when they find out this fee is necessary.

Then there are prepayment fees, which are especially common with debt funds. Most debt funds want to make a minimum yield on their investment, which they make via interest. If a developer pays off their loan before they reach that minimum yield, it can result in fees.

It is possible negotiate some of these fees down. So, be sure to bring that up before closing on the loan.

4. Don’t forget third-party costs

Developers should also be aware that loans can come with terms that have nothing to do with payment. Every lender is different, and some may have more stringent requirements than others.

For example, a loan may require the borrower to meet a certain level of insurance coverage or pay a third-party to monitor the construction process. Some lenders require developers to secure a performance bond on the general contractor heading up your project, which could be 1.5% to 2% of the loan’s hard costs, making it a really big expense.

Some third-party costs can also be negotiated. For example, if the general contractor on a $20 million project has projects worth over $100 million on their balance sheet, there may not be a need for a performance bond. There’s no question that contractor can deliver a $20 million project.

5. Plan for the future

Hotel developers working on ground-up projects should always keep in mind the possibility of refinancing down the road.

In fact, most developers will want to refinance out of a high-interest construction loan within a year or two of the hotel opening and its business stabilizing. Developers should run the scenario of that refinance so that they can be confident that they’ll be able to take this step when the time comes.

While construction financing may be more costly in 2024, it remains available. Knowing what to look for when applying for your next loan can help you save money and avoid many headaches in the long run.

Contributed by Ryan Bosch, principal, Arriba Capital, Scottsdale, Arizona

The views and opinions expressed in this column do not necessarily reflect the opinions of Hotel Investment Today or Northstar Travel Group and its affiliated companies.