Making Constructions Loans Much More Profitable

Increasing Lending Profitability

Let’s Make a Deal was a game show that originated in 1963 and starred Monty Hall. Audience members were offered a gift and then asked if they want to trade it for another gift of unknown value. Hilarity ensued when we watched people trade luxurious Hawaiian vacations for a pack of goats. However funny, we see uncanny analogies between Let’s Make a Deal and some common banking scenarios.  Last week we had another opportunity to play the Let’s Make a Deal Game with a live commercial loan.  We had three bankers looking at making a commercial loan, and each banker chose a different loan structure to maximize profit and decrease risk for the bank.  In this article, we will analyze a commercial loan and consider the three options chosen by the bankers to determine which door had the better prize.

 

The Loan: A Bird In the Hand  

 

The commercial loan under consideration is to a new customer to the bank looking to construct a spec, four-unit industrial property for $3mm.  The loan is a $2.1mm senior, secured credit facility, structured as a construction loan followed by some type of back-end financing.  This is where the CEO, the CCO, and the lender became our Let’s Make Deal contestants.  Each player wanted to offer the borrower a one-year construction facility, the CEO wanted to offer a one-year interest only (IO) post-construction and then have the loan due.  The CCO wanted to offer the one-year IO post construction and add a two-year mini-perm at the end.  Finally, the lender wanted to offer a one-year construction, one-year IO, and add a 20-year, fully amortizing permanent (perm) takeout.  The options are shown diagrammatically below.

 

Construction Loan Comparison

 

 

Each banker was willing to make the construction loan.  But each banker had a different perspective on the best structure for the bank from a risk/return perspective: a) the IO period only, b) mini-perm after the construction, or c) perm loan after the construction.

The CEO’s reasoning was this - if, in post-construction the borrower cannot find suitable tenants for the property, the bank should have a hard repayment date (one-year for construction and one-year IO period, or two years total) to be able to assess the risks and remake or amend the credit as necessary. 

 

The CCO had a different take on the structure – if the borrower cannot find suitable tenants two years after commencing construction, how would a hard repayment date help the bank?  Better to have a take-out facility in place so that the bank is not taking a default and then a troubled debt restructuring (TDR) risk.  With covenants, the bank would have the opportunity to restructure the loan or take other corrective actions, but at least the borrower has financing after tenants are in place.  The CCO proclaimed that if the industrial project does not cash flow in two years, the bank should not rely on the “greater fool theory” that another lender will take the bank out of its trouble.  Further, unlike a business that demonstrates soft financial performance and gradual decline, this industrial project, with only four tenants, will either cash flow or not at the end of the construction period.  Finding another lender to take a loan on a failed construction project will be difficult.

 

The lender has a different perspective – if the mini-perm is a backstop for the borrower and it also serves to protect the bank, why offer a two-year mini-perm where on a 25-year amortization the borrower has only repaid 3.5% of the loan.  Why not offer a 25-year amortization with a 20-year maturity (referred to as a “25/20” structure) where at the end of the term, the borrower has repaid 67% of the loan balance.  If the borrower is successful in renting out the four industrial units, those leases will have ten to 20-year terms with five-year renewal options.  Why subject the borrower to a refinance risk in year two or year four?  Offer a 20-year perm takeout.  If the borrower is not successful in renting the space, the bank has the same amount of principal at risk with a two-year commitment as a 20-year commitment.

 

Our Analysis

 

We analyzed the three options available to the bank and demonstrated the risk, the revenue and the ROE for each option below.  

 

Construction to Perm Profitability Comparison

 

 

The far superior option is the construction loan with the perm takeout.  This option offers the lowest risk (lowest projected annual probability of default), the highest revenue and highest return on equity (ROE).  Intuitively, all of this makes sense.  The biggest risk in the project is that 12 months from today when the project is expected to cash flow, the economy turns and the projected rents do not materialize.  This risk is common to each of the three options.  However, the first two options just create additional credit and interest rate risk for the borrower to manage and, because of the shorter-term revenue stream, the first two options also are expected to generate less revenue.

  

Conclusion

 

Knowing when crucial risks arise in the timeline of a project can help bankers understand how to mitigate credit, interest rate, and liquidity risks.  Sometimes, bankers strive to shorten credit commitments, thereby forcing customer churn, and, inadvertently, jeopardizing profitability.  Where shortening commitments can result in less risk (such as lines of credit, asset-based finance or high-risk mezzanine financing), care must be taken when choosing maturity triggers.

 

If the banker wants a certain level of control during the life of the loan, covenants can often accomplish everything a banker wants without the added liquidity risk and risk to profitability. In an attempt to lower risk in amortizing senior secured facilities, shortening maturities can be like trading a potentially very profitable loan, for a goat.