While construction financing remains affordable, it’s much harder to find as many capital sources beef up their underwriting criteria.

Lenders are requiring developers to maintain higher levels of debtservice coverage, and even to put their own balance sheets on the line for new projects. Loan-to-value (LTV) ratios have also fallen sharply in the wake of the credit crunch.

Lenders’ newfound toughness on underwriting criteria marks a return to historical norms. Recourse has become a common feature on floating- rate construction debt after briefly disappearing at the height of the market’s frenzy, and debt-service coverage ratios (DSCRs) have risen in the first half of 2008.

“Recourse is again a big issue on construction loans,” said Phillip Carroll, a senior vice president of the Income Property Group of KeyBank Real Estate Capital. “Lenders are going back to where they were three years ago.”

Underwriting tightens

Through the first half of 2008, most of the regional and national banks—including Wachovia, Bank of America, and KeyBank—grew more conservative in the DSCRs of their construction loans.

In the fall, many financing sources were offering a 1.15x DSCR in strong metro areas like New York and Los Angeles and a 1.20x DSCR in secondary markets. They have since moved to 1.20x DSCR in primary markets and 1.25x in secondary metro areas.

In markets where cap rates remain low, such as Southern California, the ability for developers to extract maximum leverage has dwindled.

Leverage in such markets is generally maxing out at a 70 percent LTV ratio, according to Paul Brindley, a senior managing director at Holliday Fenoglio Fowler (HFF).

Banks are scrutinizing deals much more closely now than they did a year ago, Brindley said. “Every lender a year ago would’ve been going to 80 percent LTV, almost regardless of what the cash flow looked like,” said Brindley. “But you’re getting less leverage today. There’s plenty of mezzanine available for construction loans, but it happens to be very expensive.”

Lenders are also requiring developers to have “more skin in the game,” or for developers to take on a greater degree of risk in a construction loan. Lenders are asking for more equity to be in a deal before they get comfortable issuing the loan.

But equity and mezzanine debt are much more expensive now than they were in the second quarter of 2007. Mezzanine providers that were charging rates of around 14 percent in the second quarter of 2007 were quoting deals in the high teens and low-20 percent range in June 2008. Equity providers have also raised their prices to the mid- and upper-20 percent range, up from the high teens and low-20 percent range in the second quarter of 2007.

In the past, deferred developer fees were viewed as a form of equity, but those days are gone. “The deferred developer fee is not being looked at quite the same way as it had been. Construction lenders want to see cash,” said Phil Melton, a senior vice president at Grandbridge Real Estate Capital. “It used to be that we could make the case, ‘They’ve got $800,000 in deferred developer fee.’ But now, construction lenders say, ‘So? Where’s the cash?’”

With all of this increased scrutiny, developers are having a harder time finding construction financing. HFF said that it is seeing more demand for its services in lining up construction financing for developers.

“Typically, much construction financing is just done with developers that have a relationship with a bank,” said Brindley. “But now sponsors need more help in lining it up, and we’re seeing more demand for our services to help arrange it.”

Affordable rates

In many ways, the pricing and underwriting of construction loans have followed the same trends that permanent loans are undergoing.

Though lender spreads have grown in the last year, the all-in rate for construction loans has remained stable in the first half of 2008, thanks to declining benchmark rates.

Rates on construction loans often float over the six-month London Interbank Offered Rate (LIBOR). The six-month LIBOR was at 2.9 percent in early June, compared to a 4.5 percent rate at the start of this year. This 160 basis point drop since January has helped to keep construction loans affordable.

But lender spreads are widening. In November, typical construction loans featured spreads of between 160 and 200 basis points, but by early June, that figure had risen to a range of 220 to 300 basis points. Given a 2.9 percent LIBOR, the rise in spreads equates to an all-in rate of between 5.1 percent and 6 percent.

The strongest deals in the strongest markets were getting spreads of 175 to 200 basis points over LIBOR in early June, according to Melton. But on the flip side, those developers seeking non-recourse money on value-added deals are paying a premium for it, with spreads reaching up to 400 basis points or more in early June.

FHA redux

As construction lenders grow more conservative in their underwriting and less experienced borrowers have a more difficult time finding financing, construction permanent loans offered by the Federal Housing Administration (FHA) have witnessed an uptick of interest. The FHA’s flagship Sec. 221(d)(4) program features a 90 percent loanto- cost ratio, a 1.11x DSCR, 40-year amortization, and is non-recourse. What’s more, developers can lock in the interest rate for both the construction and permanent loan at closing.

Borrowers were getting interest rates of between 6.25 percent and 6.5 percent for a Sec. 221(d)(4) loan in late May, down from as high as 6.75 percent last fall.