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How rising construction costs are reshaping new and existing lending opportunities

Players across the capital stack are building more barriers in deals to counter expense risk.

The upward swing in construction costs, raw material costs and labor shortages are forcing lenders to adapt how they carve out deals for new and rehab construction work in their portfolios.

With conflict rising in Ukraine and Russia, some industry watchers anticipate that supply chains and raw material sourcing could be further disrupted and delay ongoing and new construction throughout the commercial real estate landscape.

As of 2021’s end, Turner’s building cost index had risen to a value of 1230, marking a 1.91 percent quarterly increase from the third quarter of 2021 and a 5.04 percent increase from the prior year’s end.

Mortensen’s construction cost index shows a similar increase in pricing on non-residential projects on a nationwide basis. Mortensen’s index clocked in with a national value of 137.8 at the end of 2020 and rose to 167.4 by the end of 2021. Portland, Seattle and Denver rank as three of the costliest cities for new construction as of 2021’s end, surpassing the national index value by nearly 12 points in Seattle’s case.

Supply chain stalls, skilled labor shortages, subcontractor backlogs and the war in Ukraine are all adding more complexity to an environment marred by rising prices in steel, copper, aluminum and related raw material, according to Mortensen’s research.

Ira Zlotowitz, CEO and founder of Gparency, said the Russo-Ukrainian war in particular throws a wrench into predicting individual investor behaviors atop the direct hit anticipated for oil, natural gas and other exports from Russia and Ukraine.

Rob Gilman, partner and co-leader of Anchin, Block & Anchin’s real estate group, told Real Estate Capital USA that the disruption to new construction, rehabs and build-outs can also bring more issues with tenants who want more concessions because of the delayed access to their leased properties.

For some commercial real estate private equity managers like Pembrook Group, the broadly muddled construction environment has forced the company to require that all subcontracts be bought out and signed to lock in prices in order to avoid future changes in pricing.

Stuart Boesky, chief executive at the New York-based manager, told Real Estate Capital USA his firm is building in bigger contingencies to cover price uncertainties and trying to source developers with more liquidity.

In Pembrook’s case, the supply chain issues have lead the firm to opt for more uniform building designs that do not require bespoke manufactured components. Boesky said choosing more plain vanilla parts is safer in the current environment where an international or local manufacturer could be forced to close because of pandemic-related or other reasons.

Shlomi Ronen, managing principal and founder at Dekel Capital, said the supply chain issues in turn become scheduling issues and compounding cost issues for developers and lenders alike.

In one instance, according to Ronen, a job that was bid out in August 2021 now carries a hard cost that is 20 percent higher compared to where it came in six months ago. He said the upward cost swing is forcing financiers to revisit what is being built from material sampling and beyond in order to find cost savings and value engineering options.

The Los Angeles-headquartered construction lending specialist Parkview Financial has historically guarded against construction cost risk by pairing experienced builders that have good subcontractor relationships with guaranteed maximum contracts and requiring borrowers to sign documents with a loan-balancing provision.

Fabio Baum, managing director at Parkview, said the firm’s deal structure allows it to value-balance the loan either through a pay-down or through the borrower contributing more equity to a given project. In such a scenario where a project will cost more or take longer, Parkview delays funding until the loan can be brought back into balance.

Baum said the expected tick upward of interest rates is also factoring into the construction lending picture at present. With most loans in the space funded on a floating-rate basis, he said there can be increased costs of the loan throughout the construction period, especially when not accounting for such increases during the underwriting process.

Rising construction costs have not deterred the entry and expansion of debt funds into the construction space, Ronen said. He added that new funds getting into the space are taking a little more risk to get yield in an already compressed environment.

Baum said the same debt funds moving into the space are largely competing for the same product and creating a recipe for problems because of the lack of understanding of risks and intricacies within the construction lending space. He said some debt funds and private equity funds participating within the category may start to get more government regulatory scrutiny, which could alter the landscape considerably if compliance conditions change.