Paul Rahimian is CEO of Parkview Financial, a direct private
lender in Los Angeles. He currently manages a debt fund that
provides construction financing to ground-up real estate
development projects throughout the Western United States.
He founded Parkview Financial in early 2010 and has since
originated hundreds of commercial and residential loans. Distinguished from
its competitors by having dedicated in-house finance and accounting
professionals, Parkview is widely recognized as a pioneer in the lending
industry. Reach Rahimian at (310) 996-8999 or firstname.lastname@example.org.
<< Value continued from Page 31 There are many reasons why construction costs have risen so dramatically in recent years. After the financial crisis that struck a decade ago, a large number of skilled and qualified workers fled the construction workforce. During previous recessions, contractors often sought out temporary work during
the downturns and returned to construction after the market resettled.
But the aftermath of the Great Recession was far more profound than any
of these contractors had seen before. Many workers could not afford to wait
the extreme length of time required for this market to successfully rebound.
Construction was, in effect, left at a complete standstill from about 2010
through 2013, and many journeymen abandoned the industry altogether.
To make matters worse, the recession also significantly reduced the
number of new workers entering the construction industry, leaving this
void unfilled for the foreseeable future.
Roots of rising costs
The impact of this labor shift was not fully realized until 2016 or so, when a
balanced economy led to an increase in construction. But this new boom
was ultimately met by an extreme shortage of labor.
As more new developments were planned, the demands for construction
were unable to be met with the amount of labor available. As a result, developers and general contractors began to “steal” workers from other projects,
traveling to competing sites and poaching their employees by offering them
higher wages or better benefits.
To combat this, many contractors hired security guards to stop any labor
poachers. In previous economic cycles, acts like this were unheard of, so
they signified how deeply the recession and resulting labor depression
had affected the market.
Contractors also have been challenged recently by a lack of foreign-born
workers. Undocumented immigrants, for example, account for about
13 percent of the construction workforce in the U. S., according to the Pew
Research Center, and those figures exceed 40 percent in border states like
California and Texas. From 2006 to 2016, the number of immigrants working in the construction industry declined by 5 percent, according to the
National Association of Home Builders.
In addition to the escalation of labor costs, there has been a dramatic
increase in recent years in building-material and land-acquisition costs.
As the economy began to heat up again and development resumed, land
costs inflated just as quickly.
In many areas, commercial real estate values have surpassed their 2007
peaks. Developers have actively sought out entitled sites that are ready to
break ground in order to reduce the time exposure on their deal and allow
them to begin construction immediately after purchasing a permit-ready
site. The speed of purchases has led to a massive increase in land costs that,
when coupled with increased materials and labor costs, is significantly
amplifying the overall cost of construction.
Lenders feel effects
All of these factors have affected more than the construction industry
itself. They have reverberated all the way into the sphere of construction
lending. As costs increase, developers find themselves squeezed in terms
of their profit margins. Developers are generally optimistic by nature,
however, and they make strong bets that once a construction project is
complete, local wages will rise and so will rent prices.
Therefore, developers can easily justify increased costs, hypothesizing
that these movements will inevitably lead to higher profits. Lenders, however, are inversely pessimistic and do not see the world through the same
lens as developers. This divergence in views causes a significant disruption
in the marketplace and has led to the derailment of many projects.
Traditional banks and private lenders base their financing on a
loan-to-cost (LTC) ratio. Banks may be more conservative in their numbers
than private lenders, but the underlying concept is the same. Banks will
often lend up to 65 percent of a developer’s costs, whereas private lenders
may come in with 75 percent or more of all expenses — including soft and
hard costs, as well as land values.
Mortgage brokers and borrowers might wonder, if lenders base the loan
amount on LTC, why would the increase in construction costs affect loan
approval? Shouldn’t lenders proportionally follow LTC ratios and therefore
lend more capital in relation to the costs? Developers likely work under
this assumption but, for lenders, the issue is far more complex.
Lenders see another variable inside the puzzle, believing that construction
costs inhibit the creation of profits and, therefore, they see developers as
essentially working for free. By their estimation, the overall value of the project
has not increased by the same percentage as the rise in construction costs.
Lenders may feel that, for some development deals, completing the process will not lead to the creation of any value. Although construction lenders
base loan approvals on LTC, they ultimately require limited exposure on the
evaluation side of the deal.
Some lenders, therefore, come with set limits. Others may not specify a strict
limit but generally exercise caution if the loan amount exceeds 65 percent of
the project’s estimated value after construction. Even if they lend upward
of 75 percent of the costs, they are wary of loans that will comprise 70 to
72 percent of the project’s future value. At that point, lenders find themselves
questioning whether participation in the project makes sense at all.
So, if construction costs continue to rise, what can be done to help remedy
the situation? For mortgage brokers working with developers, take care
to ensure that the project budget is structured at a realistic price point.
Inflated costs will end up hurting the development because experienced
lenders will naturally scale the numbers back toward reality.
Take a thorough look at local rent statistics and do not expect growth
over the next 24 to 36 months. Maybe the economy will expand and rent
prices will rise, but this should be a bonus rather than an expectation.
Continued on Page 34 >>