Construction lending is a tough business. Frankly, except for institutions with real expertise in the actual process of constructing a building, who have experience in dealing with owners, contractors, architects, subcontractors and the like and really know how a construction project actually progresses from first dollar in to last dollar out have no business being in the construction space (but that won’t stop fantasists with money burning a hole in their pocket imaging outsized yields jumping in).
Banks and, to a lesser extent, insurance companies, have been the principle lenders to the construction sector. The institutions have invested in building out the infrastructure needed to do construction lending safely and competently. They have the right relationship between teeth and tale to compete (having to build that out for a new competitor in the space is a huge barrier to entry).
The demand for construction dollars exceeds the supply and is likely to do so for the foreseeable future. The great swath of traditional portfolio lenders either don’t have the dry powder (because they’re fully invested) or don’t have the technical competence to fill the hole and they are unwilling to invest (to build it out). The banks, which is every developer’s first call, are being pinched by regulatory pressures (particularly the non-money center banks who have CRE exposure over a 300% regulatory threshold) and by higher risk-based capital charges for HVCRE (High Volatility Commercial Real Estate) assets which, frankly, are most of them. Moreover, the data center phenomena (which will at least continue until we have our Matrix moment) is soaking up capacity out of the sector while the very best projects with the best stories, prospects and backing, are emptying the till leaving little for more run-of-the-mill construction projects.
If traditional lenders cannot meet demand, someone will step up to the plate. That gap of necessity will be filled by non-depository financial institutions (NDFIs) using other people’s money (OPM) to juice their return by using structured finance technology. Look, no one would do the brain damage of going this route if there was an easier and cheaper alternative, but there’s not. The market needs liquidity and we’ve fully tapped the more customary sources. Only that makes the brain damage and probably heightened cost of a structured finance solution necessary.
Assuming a motivated player assembles the relevant expertise (and yes, it can indeed be vended, it doesn’t always have to be in-house), structured finance can provide a funding solution. The funding provided through this type of technology will undoubtedly be more expensive than might be available at the traditional banking or lifecos lending windows, but needs must when liquidity is scarce. (I’m talking about pooled deals here. I suspect SASB structures might be a bridge too far, at least early on.)
There’s a lot to think about. My list of issues is far from exclusive but I hope it’s a place to start a conversation.
If you want to play in this sandbox, you probably start with an existing CRE CLO or a bespoke new vehicle designed exclusively to do construction lending. The vehicle will make construction loans to borrowers which, in all relevant respects, will look like traditional construction loans made by an established portfolio lender (security arrangements, covenants, reps, draw mechanics, servicing, reporting, completion and/or P&I guarantees, etc.).
The source of funds for these loans would be dollars invested by the same broad investor cohort that currently funds all CRE structured finance, allowing the sponsor to access a vastly deeper investor base than would otherwise be available to fund construction projects. The issuer will fund the loan from the proceeds of Variable Funding Notes (VFNs) issued to the investors. The VFNs will also be credit tranched which will allow the sponsor to attract investors up and down the yield/risk continuum. While more complex capital stacks could (and certainly will) be engineered, I expect, early days, will see two-tranche models with the senior tranche purchased by many of the same banks and lifecos that are and were playing in the construction market (and with substantially better RBC treatment for securitized exposures). Not to put my finger on the scales, but the obvious first movers here are one of our existing NDFIs with an affiliate lifecos where splitting the junior and senior positions internally and whacking up yield and return should be considerably easier than between completely entirely unrelated parties.
We have experience with VFN notes used to fund future funding obligations. These structures were commonplace in the (I hate even to mention the name…CRE CDOs) pre-GFC era. Those notes were used in the day to fund future advances before the current kabuki theatre around “seller’s two quarter future advance estimates” and “segregated liquidity” became au courant. While reconciling advances to construction draw mechanics will be complex, it’s entirely doable.
Cost overruns are a reality in construction projects. Our structure would need to provide for enough headroom in the VFNs to deal with reasonably anticipated cost overruns on individual loans. Perhaps we would see some species of unfunded subordinate security in the capital stack retained by the sponsor (maybe made more attractive by the allocation of fees or a higher coupon) that would be accessible exclusively for overruns, rather mimicking the pre-GFC senior class at the top of the capital stack used for future advances. Having this in place will probably provide comfort to the noteholders that cost overruns will be covered, they won’t be simply relying on the possibility that the sponsor will infuse more equity if needed. (The draws would be mandatory at the direction of the servicer.).
Can the senior tranche be rated? That would obviously be essential for best pricing. The issue presents in two ways; first, the ability of the investment grade buyer to meet its obligations under the VFN and secondly, the security for the resulting loan secured by a non-complete, non-income producing asset owned by the borrower. Moreover, the structure will need an advancing function (more on that below). I am not aware of any of the major ratings agencies having published ground-up construction criteria, albeit Egan Jones has criteria in its project finance sleeve, but that won’t work in most cases for a number of reasons and at the moment is largely limited to private letter rulings. However, as night follows day, if there’s an unmet need for construction lending and it is to be met by a structured finance product, the clamor for a ratings model will be enormous and one or more of our ratings agencies friends are likely to step up. (Please take this as an invitation to all my NRSRO friends, to become a first mover and get a lead story in the paper of record for our biz, Commercial Mortgage Alert.)
Oh yeah, we need to talk about advancing. The master servicer, or someone, will have to agree to advance if we’re going to rate either timely receipt and/or ultimate recovery which will likely be obligatory in order to sell bonds. Will a master servicer stand up? Probably not willingly, but as with most of the new features with this structure which are rather novel, this will happen if it must. Need drives innovation. If the master servicer won’t stand up, might advancing be achieved outside a master servicer contract? Could be. Would it be expensive? Yeah.
Also central to this whole endeavor will be the definition of the underwriting box for loans to be acquired or funded. This will be critical for the investors and for the ratings agencies. Early on, that box would probably be very tight. We’d see the full panoply of acquisition criteria from regular way CRE CLOs, plus a suite of construction-specific criteria which largely can be pulled directly out of existing portfolio construction documentation. A tight box would probably be paired with some form of waiver to take into account ameliorating factors, in all cases subject to the servicing standard. We know how that works.
As the deal documents would otherwise in large measure mimic existing CRE CLO best practice documentation including an inclusion of a note protection test, SIGMOD/administrative mods, substructures and the like.
Obviously, asset management will be hugely critical here as we need to merge the portfolio lenders traditional construction lending protocols with the asset management and servicing regimes of structured finance. This will confront us with a number of complex and rather novel questions, but I’m confident that we can get there. There’s likely to be specialized sub-servicers to deal with the whole construction process who will be needed to be added to the structure. Will that be more expensive? Sure, but that’s baked into the cake.
One of the biggest issues in the whole servicing topic is, of course, the approval mechanics. How to approve advances, approve change orders, approve other borrower-requested waivers and all the rest of the decisions that will of necessity accompany a construction loan? Will our traditional directing certificate holder structure work here? Maybe, but maybe not, and maybe many or most of these decisions will be delegated to a third-party (under the servicing standard) with limited input from the controlling class. Perhaps the controlling class has a right to override in some cases; perhaps has a right to require the appointment of a new construction servicer. These mechanics can be worked out.
Risk based capital considerations will be important. For banks and lifecos, risk based capital will attach to the funded and unfunded portions of the senior VFN. As this is a securitization exposure (for the banks), there may be a pickup over a straight-up construction loan in terms of risk based capital. (Typically in loans with unfunded commitments, the unfunded portion of the exposure attracts a lower RBC charge and presumably that would be true in this case as well.)
As in all structured finance, double taxation must be avoided and there are several paths forward here. If the issuer is a mortgage REIT, or a wholly owned subsidiary of a mortgage REIT, we know how to structure REIT compliance for CRE CLOs. The REIT structure does, of course, have its annoying complexities and, perhaps most importantly, require the sponsor to retain all non-investment grade securities that might be issued. That’s somewhat inconsistent with the whole OPM notion, so other alternatives will undoubtedly be explored. If the structure could be limited to two classes of securities, tax transparency can be achieved without the complexities of the REIT rules (and this, frankly, is rather likely in early days deals). Finally, if the structure needs to be designed for maximize economic return, which would require multiple classes of securities, a REMIC structure could be used. In this case, we would employ a technology we call a pancake REMIC (see my commentary of October 8, 2025 for a more detailed description of this technology, or just call Will Cejudo at Dechert). Suffice it to say for our purposes, a pancake REMIC means subsequent construction draws will be included in sequentially remote REMICs. I know it sounds a bit worryingly complex, but it’s just accounting and will have no real impact on the functionality of the structure.
On this point, importantly, we should find comfort in the fact that the traditional tension between a senior and a junior bondholder in a typical structured finance transaction will be ameliorated here by the simple fact that in a construction project, the asset is generally not worth terribly much until the issuance of certificate of occupancy. Cliff-vesting on COs. This would better align the interest of all the bondholders to make decisions that would be more akin to the decisions a portfolio lender would make in a traditional portfolio loan.
Obviously, there’s lots to be resolved here, but nothing that, with a fair amount of imagination and a compelling need can’t be mastered. Look, necessity is the mother of invention. We would never undertake the brain damage that this will entail if doing so wasn’t compelling. But if the market says there’s a question that needs to be answered, then we’re going to answer it. If there’s demand for construction dollars which cannot be met by the customary sources of supply, this will happen.
The great thing about being a card-carrying member of the chattering class is that I can boot some of the tough issues to the folks actually charged with doing the deals. All I need to do is imagine solutions. I know this going to be hard, but I firmly believe it’s needed and consequently is doable. (Take heed, Stewart McQueen. As you are the best in this business, I suspect it will fall to you to actually figure out how to make this work.) Let me again invite first mover wannabes to dive in. I virtually guarantee you above the fold coverage in Commercial Mortgage Alert (I know Bob Mura is paying attention).
Let’s get started.
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