Reflecting the continued flood of capital generally targeting income properties, some builders should even expect cold-calls from new lenders entering the construction arena.

However, chances are the conversations will get around to a particularly challenging topic: rising construction costs. It’s a tough one for lenders to get around. They’re generally unwilling to provide higher loan proceeds unless borrowers can clearly demonstrate commensurate upward movement in rents and operating incomes.

“Construction lenders are very reluctant to trend rents” in calculating construction loan proceeds, noted veteran mortgage banker Brad Sevier, who with partner Mike Guterman just formed Highland Realty Capital. “They’ll say, ‘We’re not getting paid enough to take that kind of risk.’”

“It’s not an easy issue to deal with,” agreed Andy Weiss, managing director at Meridian Capital Group, a busy multi-housing construction lender. Apartment developers in most cases just have little option but to come up with more cash when costs unexpectedly rise, he said.

But there’s plenty of better news on the construction-financing front. Experts aren’t expecting much movement in first-lien leverage amounts (still typically in the 80% vicinity), but the competitive environment should keep capital costs quite attractive, with perhaps even some downward pressure ahead. Favored borrowers may well see some relief with respect to personal recourse provisions.

New players

The fundamental factor is the amount of capital targeting multi-family construction loans. Despite the banking sector’s ongoing consolidation, it appears the roster of active construction lenders will actually lengthen in 2006.

Wall Street investment banking houses are looking to securitize construction credits; offshore banks remain attracted to relatively higher American yields; and construction trade-union pension funds may well become bigger players.

“No doubt the Wall Street firms are looking at construction lending,” said E.J. Burke, executive vice president at KeyBank Real Estate Capital. “If they can figure out a way to securitize construction loans economically, and get the ratings agencies on board, they may become pretty active near-term.”

Offshore banks are already beginning to fund U.S. multi-housing construction loans, and they seem poised for more, Weiss said. For example, Meridian recently arranged a non-recourse construction loan for a Trammell Crow Residential (TCR) condo development from an offshore bank that Weiss declined to identify.

“Eventually we’ll even see some Chinese money trickle in,” added Peter Linneman, professor of real estate, finance and public policy at the University of Pennsylvania’s Wharton School of Business.

Even though rental specialists are vying for construction lenders’ ears and dollars with an unprecedented wave of condo developments, capital costs in 2006 should remain at bargain rates – or maybe become even a bit more attractive. If today’s already thin construction loan spreads move at all, they seem far more likely to tighten than widen, said Linneman.

Indeed, spreads over floating-rate indexes on developer TCR’s latest construction loans actually narrowed some 15 to 20 basis points over the last few months of 2005, said Michael Melaugh, TCR’s executive managing director of capital markets. The banking consolidation wave notwithstanding, the ever-bigger survivors remain quite active pursuing construction lending opportunities, Melaugh said. “They all need projects to hang their paper on, and that tends to depress the rates they charge.”

For his part, Sevier doesn’t anticipate much change in the pricing range bigger banking companies charge – roughly 200 basis points over the 30-day London InterBank Offered Rate (LIBOR) for “platinum”-grade deals, compared to a high of maybe 350 over the 30-day LIBOR for riskier nonrecourse credits. Developers working with smaller banks should expect their rates to continue at prime to prime-plus-one point, Sevier added.

KeyBank’s Burke sees the competitive environment generating more nonrecourse loans for the strongest projects in the biggest markets. In addition, lenders that are looking to fund sizable projects are generally aiming to improve borrowers’ recourse liabilities by “segmenting” the risk by bringing in one or more lender partners, Burke said.

While the multilender participation is pretty much “transparent” from the borrower’s perspective, carving the credit into two or three tranches can better match the risk of a nonrecourse deal with an appropriate lending team, he said.

Some lenders are even starting to offer fixed-rate construction/permanent combinations including a slight premium in the long-term rate in exchange for taking the construction risk and committing early to the take-out, Sevier said. Developers have shown willingness to pay the premium to reduce the risk that permanent rates might rise during the construction period, he continued. Lenders (mostly large banks and life companies) under these arrangements typically securitize the permanent mortgage after the construction rollover, he added.

Trend watch

Looking into 2006 and beyond, developers see improving opportunities and generally look forward to positive news on the finance front. But rising construction costs remain something of a discouraging wild card.

The National Association of Home Builders is projecting annual overall (rental and for-sale) multi-housing construction of about 350,000 units for both the coming year and 2007.

Nevertheless, senior executives with some of the biggest publicly traded apartment developers worry that rising costs could limit activity. “We wouldn’t be surprised to see construction costs rise another 10% to 12% over the next 12 to 18 months,” said R. Scot Sellers, chairman of Archstone-Smith, a real estate investment trust.

“The rise in construction costs is going to take some of the momentum out of the 2006 delivery pipeline,” said David Neithercut, president of Equity Residential Properties. He and his colleagues also see pressure in the labor arena boosting overall operational costs in 2006.

Even those cost increases have an upside, according to Sellers: “One nice thing about rising costs is that it tends to increase the value of existing assets.”