Industrial Midwest

Selling your development to your lender

For the first time in years, the Chicago industrial market’s vacancy rate is less than 10 percent. Chicago’s more than 1 billion-square-foot industrial market contains high velocity distribution space, old fashioned warehouse, manufacturing buildings, laboratories and many other types of uses.

By Jerry Rotunno

Senior Vice President-Associated Bank

For the first time in years, the Chicago industrial market’s vacancy rate is less than 10 percent.  Chicago’s more than 1 billion-square-foot industrial market contains high velocity distribution space, old fashioned warehouse, manufacturing buildings, laboratories and many other types of uses.  There are submarkets that have low vacancy and micro-markets within submarkets that have few options for certain uses.   However, it is important to note that our industrial vacancy rate is higher than all other gateway markets.

So, what about your development?   We can all point to cases in which speculative development did not go well during the last business cycle and this continues to remain top of mind with lenders.  How then do you convince your banker that this time it will be different?  The key is to show that a user will lease the project within a short time after completion.   But remember, it’s not just your loan officer that needs to be convinced.  The loan has to be approved by a committee, whose members may not know your submarket.   You will need to be prepared to discuss the global economic trends as well as the details of the local market demand drivers. And, you need to have a Plan B - what you will do if leasing does not happen at the pace and rental rate originally projected.

You should start by speaking globally about the need to build locally.  The committee members need to know the broad economic trends that affect the market.   Most are not real estate bankers and don’t know the local market.  Often they are in cities with economies that are different than the Chicago economy.  They are aware of general economic trends as they approve loans across all industries.   They know how globalization, government regulations and supply chain consolidations affect the businesses in the markets that the bank serves.  You will need to show how these same trends affect Chicago and your submarket.

Remember that bankers relate to numbers and charts.  The loan officer needs to know the details of the demand and supply of the submarket. You will need to precisely define the market for your project including the type of user and its preferred unit size, ceiling height, building depth, parking needs (cars and trailers), dock and door ratios and preferred geographic location.

Submarkets with a robust recovery are those in which construction is needed so be prepared to show historic absorption for the last few years.   In fact, lenders like to see projections of industrial space absorption as trending in an orderly, upward sloping straight line.  Prove your case by detailing how the demand trend line has moved up in recent quarters and the overhang of existing space is now being absorbed.  What has changed since the last building cycle?  These are the factors that might move the direction of the market.  This could be new infrastructure like the extension of Interstate 355 or O’Hare expansion.  Factors like natural gas prices, right-to-work legislation or truck driver shortages will change market demand in ways we did not see in 2007.

Discuss the current supply and how new construction will compete.  Many existing spaces are stub spaces in partially leased buildings that limit their competiveness. A new building will probably be more expensive than an existing building.   Point out design advantages such as cross docking, energy efficiency or extra trailer parking in which a user will see the value of a new project’s higher rent.

Explain the barriers to new construction.   Mature markets with limited available sites or restrictive zoning are examples that limit the competition.  Compare your site’s relative advantages and disadvantages to competing sites.

What if the leasing of your project does not happen within the expected timeframe or the rental rate projected?  Lenders cover this risk by requiring at least 35 percent equity to total cost.  The equity requirement covers many contingencies.   Higher rents are required for new construction to be economically feasible.  With 35 percent equity, the bank does not need to assume the risk that these higher rents will be achieved.  Banks look at the minimum rent required for the property to sell for more than the loan balance.  Calculate the minimum leasing required for the net income to cover the interest cost.   Interest could rise above today’s historically low rates, so your bank will build a higher interest rate into its calculations.   A standard assumption is a 6.00 percent interest rate with a 25-year amortization schedule.

Banks allocate capital based on the risk inherent in the loan.  Each loan has a capital stack much like a commercial real estate development.  Think of the debt source as deposits and the equity as an allocation of the bank’s capital.  When a speculative project does not meet its leasing projection, regulators require the bank to allocate more equity to the loan.  Equity cost of capital is higher than debt cost of capital. When the banker’s cost goes up, expect that this will be passed on to you, the customer, in the form of higher interest rates, larger loan renewal fees and an additional equity contribution.

Bankers look closely at the ability of the sponsor to put more capital into the project when needed.  This is required to cover additional interest carry.  Also, a softer than expected market may require more tenant improvement costs to lure tenants.

The recent absorption of industrial space built prior to 2007 has created some opportunities for speculative industrial construction.   You will need to show your bank that demand for your new project is not met by existing supply.  Discussing global trends and local market demand characteristics will help make your banker comfortable that the project will succeed.  In the end, a speculative project will require the developer to contribute at least 35 percent equity and financially strong guarantors to cover the uncertainty that is inherent in such endeavors.

Jerry Rotunno is senior vice president in the Commercial Real Estate Group in Chicago.  He can be reached at (312) 552-2470 or jerry.rotunno@associatedbank.com