Imagine there’s a three-acre vacant lot for sale in a popular neighborhood in a major metropolitan area, two blocks from public transportation, and within walking distance of a highly rated public school. Or if that sounds a little too imaginary, think about a three-story building with five apartments. It’s a little run down, but the asking price is manageable, and three of the units are vacant.
While investors may jump at the chance to acquire either (or both), there may be a long journey between acquisition and construction.
“You don’t just go into it right away and build [or renovate],” explained Jonny Rahimi, a financing expert at Lev.
Investors could have the capital to acquire the lot or the building, but there may be studies, testing or other requirements for either before it’s ready for development. That means more work and, critically, more money.
A predevelopment loan can help.
What Are Predevelopment Loans?
According to the National Housing Conference, predevelopment loans “offer financing to cover a variety of development expenses — sometimes referred to as soft costs — incurred while determining the feasibility of a particular project, such as the costs of preliminary financial applications, legal fees, architectural and engineering fees and other exploratory work.”
Different lenders may have slightly different criteria for what the loans can be used for, but they all fall under the category of activities that must be completed before development can start.
What Can a Predevelopment Loan Be Used For?
These examples are just a few of the uses for a predevelopment loan.
- Site preparation: Let’s say an investor recently acquired a large plot of land where she’s planning to develop multifamily rental housing. The land, however, is zoned for agricultural purposes and lacks a sewage system that can accommodate residents. The investor can apply for a predevelopment loan to finance and build it before construction starts.
- Legal fees: Covers the costs of lawyers used for legal research on the property, sales, closings, or similar activities
- Feasibility studies: To make sure the plans for construction are realistic, given time, space, budget and other constraints
- Architectural plans: For the design and construction phases of the project
- Engineering studies: Covers the cost of hiring an engineer to analyze the land and determine the feasibility of your project before building
- Application fees: If you’re investing in and developing multifamily affordable housing, tax credits might be available to finance the project, but obtaining these credits requires additional time and money.
- Environmental testing: Tests including soil, groundwater and air, among others, might be necessary to ensure the land or the building is safe.
- Construction permits: The Department of Buildings (or a similar agency) in your city may require certain permits, like zoning permits and building permits, for construction to begin, and a predevelopment loan can cover the expenses of obtaining those permits.
Top 4 Predevelopment Lenders for Commercial Real Estate
Rahimi divided potential lenders into three groups: national commercial banks, regional or local banks, and private debt lenders. Multifamily affordable housing investors can also obtain loans through Community Development Financial Institutions, and other government and nonprofit programs targeted specifically for this type of development.
1. Banks (National Commercial Banks and Regional Banks)
Banks like Bank of America or Chase Bank, Citi, and other national commercial banks offer predevelopment loans. The term length could be approximately 1-3 years, but will vary depending on the project. Contact the banks for information on interest rates and loan amounts, or try to connect with a broker who already has that relationship.
The advantage of a bank loan (both national and regional) is a lower interest rate compared to private debt lenders. National commercial banks might have more capital to lend in general than their regional counterparts, but regional banks might have greater knowledge of your local real estate market.
2. Private Debt Lenders
Real estate debt funds lend private equity-backed capital to real estate investors and developers. Investors in these funds receive payments from the interest charged on their loans.
Debt funds, Rahimi said, “are usually able to provide a higher loan-to-value or loan-to-cost than banks but will be more expensive in interest rate.”
In a hypothetical example, for a “$10 million deal they’ll give you a higher loan than let’s say a bank would, but they’re going to charge you 8% to 10%, rather than 4%, 5% like a bank would.”
For one March, 2021 project in Boston, a private firm arranged a $6.2 million predevelopment loan for a 273 unit building.
3. Nonprofit Lenders, Including Community Development Finance Institutions (CDFIs)
Investors working with multifamily affordable housing projects can also look into national, state, or local Community Development Finance Institutions (CDFIs). CDFIs are private financial institutions dedicated to providing lending products for projects in low-income, historically underserved communities. They’re funded by the U.S. treasury, as well as individuals, private corporations and religious institutions, among others.
Two of the largest national CDFIs are the Enterprise Community Development Loan Fund and Local Initiatives Support Corporation. Enterprise’s loan fund offers $250,000 to $750,000 in predevelopment financing, with a two-year term and both fixed and variable interest rates. Local Initiatives Support Corporation provides up to $1,500,000 in predevelopment financing, with a 5-7% fixed interest rate.
4. Public Lenders (or Public-Private Partnerships)
State and local government housing and economic development agencies are another source of predevelopment financing. Sometimes these loans are directly administered by the agencies. In other cases, they may be managed in partnership with a nonprofit or a private debt lender. An example of that is New York City’s Emerging Developer Loan Fund, a collaboration between the New York City Economic Development Corporation and Basis Management Group, a private lender.
What to Include in Your Application for a Predevelopment Loan
Every investor, project, and lender is going to be a little different, but below are the basic pieces common in an application for a predevelopment loan.
- At least three years of audited financial statements, and the most recent profit and loss statement from the investor or organization applying for the loan.
- Credit check and background check
- Underwriting model
- An organizational chart explaining the project’s ownership structure
- Bios of key leaders on the project
- Schedule of any other real estate the borrowers own and any outstanding for organizations that are part of the project’s ownership
- If it’s a loan for a nonprofit developer, include a list of board members and the IRS 501 ©(3) letter
- Project budget and proposed schedule
- Project pro forma
- Evidence of site control
- Letters of interest or commitments from equity, debt and grant sources
Don’t be discouraged if your project needs more work or research before construction starts. A predevelopment loan can help you get off the ground. If you’re already in the middle of your project, a commercial bridge loan might be more attainable. If you need help, connect with an experienced broker like Jonny.