Despite the recent low interest rate environment, some projects just will not support market rate construction loans. What then is the developer to do? Over the last few years developers have begun to turn to the purchaser to finance construction of a project. This technique can be used for both residential and commercial development.
Many years ago, residential developers were able to tap earnest money deposits and use the money to fund a portion of construction costs. Renovation contractors have long done this, using significant prepayments or deposits to cover the cost of materials. However, state law or local practice in most jurisdictions changed over time to require that earnest money deposits be held in escrow until closing to protect the purchaser. In the last few years, however, states such as Florida have begun to allow the use of some of the earnest money deposits. In Virginia, the law allows the use of the full deposit if the builder/developer posts a bond to cover return of the deposits if the homes are not completed and delivered to the purchaser. As a result, using the deposits to fund all or a portion of project construction costs is now possible. Builder/developers should consider using this technique where legally permissible and seek legislation to permit it in states that currently do not.
Commercial developers are not constrained by state law but rather by the concerns of purchasers and permanent lenders who do not want to risk the purchase price without the tangible security of a completed structure. However, in the past two years we have convinced end users and lenders that a carefully structured transaction allowing the use of the purchase price to fund construction is mutually beneficial. The key to success is sharing the benefits of the reduced financing costs and structuring the transaction to manage risk. When the builder/developer does not have to pay interest at construction loan rates, the purchaser can acquire the project at a lower price. Also, in a rising interest rate environment the purchaser can lock in today’s lower interest rates on a permanent loan or corporate bond, rather than waiting eighteen to twenty-four months for a loan closing that requires completion of construction.
With the cooperation of the builder/developer, purchaser and permanent lender (and any construction lender or land seller with a purchase money loan), everyone wins. The parties can be guaranteed that construction will be completed, the project will be conveyed to the purchaser and the lender will have sufficient tangible security to protect against loss. The lawyers involved must work together to develop a Purchase and Sale Agreement, a Development Agreement, an Intercreditor Agreement and a Construction Contract with a reputable and financially sound general contractor. The Construction Contract must have a maximum guaranteed price, a strong payment and performance bond, and a carefully crafted insurance program to protect all of the parties against unforeseen losses. Once the legal structure is in place, the purchaser closes on the property (sometimes through an air rights program or a condominium format if the land itself cannot be conveyed) and disburses the entire purchase price in draws in the same manner as a construction loan. The builder/developer can then construct the building on the land or in the air space owned by the purchaser. Once construction is complete, the project documents are amended to reflect the now completed building along with any necessary modifications to the loan documents.
In the end, whether the economics of a project justify the risk is an underwriting decision. However, in some cases the technique will make the financially impossible development—whether residential or commercial—practically possible.