The Underwriting of a Construction Loan Through the Eyes of a Lender
One small step for man, one giant leap for mankind. – Neil Armstrong
By Chris Blakeslee
This summer, we will be celebrating the 50th anniversary of the first walk on the moon. I recently watched the movie, “First Man” which is about the life of astronaut, Neil Armstrong (played by Ryan Gosling), and the space mission this country embarked on that led to this historic event on July 20, 1969.
As an engineer, I am instinctively attracted to science, so I naturally found this movie entertaining. While I currently don’t practice many of the engineering principles I once painstakingly studied, I oftentimes, in my business career, find a direct connection.
Project Gemini, which was NASA’s second human spaceflight program (Project Mercury was the first), was designed to carry two astronauts into low earth orbit. Its objective was to develop space travel techniques to support the eventual Apollo mission that would transport and land astronauts on the moon.
NASA engineers concluded through Gemini it would be impossible to reach the moon with one, single stage rocket. As a result, they developed a system of staged rockets, each designed for a specific part of the mission. The larger task (or problem) of getting man to the moon was broken down into smaller problems (or stages) that engineers could manage and solve. The discipline I fall back on most from my days as an engineer is to break down a larger problem into smaller solvable tasks. By doing this, the larger issue eventually gets solved.
To make it even more complex, NASA engineers had to resolve how to design a craft (the lunar module Eagle piloted by Buzz Aldrin and Neil Armstrong) that could both land on the moon lightly without crashing, while reserving enough fuel to launch off the surface and re-connect with the command module piloted by Michael Collins. The calculations of how much fuel was needed to both pilot the lunar module to the moon and provide enough lift to get off the surface were exacting, and all interconnected. When broken down into smaller tasks, the calculations could be solved in pieces that fit together like a mathematical jigsaw puzzle – each needed to do its part to complete the entire picture.
While underwriting a construction loan is far less complicated than putting someone on and getting someone off the moon, a similar approach is taken when faced with a potential new loan opportunity. It’s best to break the larger task into smaller, more manageable problems. I describe the process as a three-legged stool. Each leg has to stand on its own or the stool (or loan) won’t function properly. The first leg to address is to determine the end value of the project being underwritten. We have to be able to determine with confidence what this number is. The second issue to address is the builder’s ability to execute and complete the project on time, within the budget. This is probably the most difficult task a lender must face. It is much easier to underwrite a loan with repeat builders who have proven that they know how to execute. The third and final leg of the stool is that the home has to sell. It has to be priced appropriately and the design has to be such that it is desirable. Through the sale, the loan is paid back and those funds are recycled into a new project. When the analysis is complete and all three tasks (or legs) are satisfied, the loan most likely will be considered for funding.
As the real estate market tightens, sloppy underwriting will reveal itself over time. Often, investors, underwriters, and appraisers all get caught looking in the rearview mirror rather than through the windshield at what lies ahead. It’s too easy to become complacent and come to the conclusion that what has worked before will work again. For instance, over the last year, construction cost increases have risen more than 30% in many cases while end prices of homes have leveled off. Ultimately, this will have an impact on the end profitability for builders and developers. It is imperative to take this information into consideration as new opportunities are contemplated.
I cannot say it enough: the challenge for all investors is to continue to be mindful of the past, but to continue to look through the windshield so you see what is coming down the road
Chris Blakeslee is the Portfolio Manager for Ascent Capital, a subsidiary of Coldstream Holdings, Inc. He enjoys staying active outside of work and spends the majority of his time on Mercer Island with his wife, two daughters, and black lab named Gypsy. Chris loves golfing, kite-surfing, skiing, surfing, tennis, and any other activity that really gets his juices flowing.