Home builders have many pain points when borrowing from banks. Chris Tereo, Co-Founder of i Fund Cities, explains some of the pain points and the benefits of working with alternative lenders for residential ground-up construction projects. Watch the video or read the transcript below to learn more.
Overview
In this interview, Chris Tereo discusses the various financing options available to home builders, comparing traditional bank financing with alternative lending solutions. He explains how market conditions and tightening guidelines have impacted bank financing and why many builders are increasingly looking at alternative options to fund new construction projects.
Bank Financing: Terms and Challenges
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Tightened Lending Guidelines:
Due to recent market shifts and incidents like the SVB situation, banks are reducing their loan-to-cost (LTC) ratios. Where builders might have once secured financing at 75% LTC, banks are now offering between 65% and 75%, meaning builders need to cover an equity gap of 25% to 35%. -
Depository Requirements:
Even when banks offer higher LTC ratios, they often require builders to deposit significant amounts (e.g., $200,000 to $300,000) into depository accounts. This requirement can reduce the effective leverage available, as these funds are tied up and earn little in return. -
Spec Ratio and Exposure Limits:
Banks typically cap the number of units that can be financed at one time (spec ratio) and impose exposure limits on the total loan amount. For example, in a multi-unit development, financing might be restricted to a couple of units until previous ones are pre-sold or completed. Similarly, exposure limits (e.g., $5–10 million) can restrict a developer’s ability to scale rapidly.
Alternative Financing: Benefits and Efficiency
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Higher Leverage:
Alternative lenders like I Fund Cities can often offer financing at higher LTC ratios (around 75% to 85%). This means builders need to contribute less equity—typically 10% to 15%—which can be a significant cost saving given the high expense of raising equity capital. -
Flexibility on Spec Ratio:
Unlike banks, alternative lenders are more willing to finance a larger number of units simultaneously if the developer demonstrates strong liquidity and execution ability. This offers builders greater flexibility in planning and scaling their projects. -
Fewer Operational Constraints:
With higher exposure limits and faster closing processes (e.g., closing draws more quickly), alternative lenders can often deliver a more efficient and scalable financing solution compared to traditional banks.
Comparative Analysis
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Cost vs. Efficiency Trade-off:
While banks may offer lower interest rates (typically prime plus half or one point, around 9.5%–10%), the higher equity requirements and operational constraints can offset these savings. When the math is run, an alternative lender—even with rates that might be 1–2 points higher—can prove more cost-effective overall due to the reduced equity gap and faster, more efficient processing. -
Speed and Scalability:
The enhanced speed in drawing down funds and the ability to finance more units at once make alternative financing especially attractive for builders looking to scale their operations quickly.
Strategic Recommendation
Chris Tereo emphasizes the importance of diversifying lending partners. Home builders should maintain relationships with both banks and alternative lenders. By doing so, they can mitigate risks associated with sudden tightening of bank guidelines and ensure access to capital when traditional financing becomes restrictive.
Conclusion
In summary, while traditional bank financing offers competitive rates, the inherent limitations—such as lower leverage, mandatory depository accounts, spec ratio restrictions, and exposure limits—can make it less attractive in a rapidly changing market. Alternative lenders, though slightly more expensive on paper, provide greater flexibility, efficiency, and scalability, which can result in significant cost savings and smoother operations over time.
