For all but the most rarified development opportunities, the business of construction lending came to an abrupt halt during the financial crisis and recession. Weighed down by the frustratingly slow pace of recovery in jobs, the outlook for new space demand has been mixed in the aftermath of the downturn. Absent a stronger outlook for absorption, and with assets trading below replacement cost in most markets, post-crisis development projects have been slow to get underway.
At least on the national stage, investors and their financiers have been reluctant to put money at risk outside of the apartment sector. Even where the risks can be well mitigated, banks’ management of legacy construction loans and their complex supervisory relationships have added to drags on activity. Signs of a thaw are emerging slowly in secondary markets. In New York and other cardinal markets, preliminary tabulations for the third quarter point to greater lender risk-taking, both in terms of higher loan-to-costs and less demanding guarantees.
With a relatively small number of new projects in proposal or planning nationally, construction loan demand has been weak heading into the fall. Similarly, underwriting standards have remained exceptionally tight for small- and mid-sized construction loans. Even in markets where standards have eased for permanent financing backed by stabilized assets, strong sponsorship and compelling proposals are not dominating inherent project risk and higher estimated loss severities.
From a peak of more than $630 billion during the first quarter of 2008, the balance of construction loans on bank balance sheets has fallen by almost two-thirds as of the second quarter. Single-family and small residential development loans have registered the most precipitous declines. But larger multifamily and commercial loans are also just a fraction of their peak levels.
The default rate on construction loans has come off its highs but remains above 10 percent as of the second quarter of 2012. Even at comparable non-performing rates, higher loss severities and recidivism rates on modified construction loans imply deeper cuts into reserves. Of bank construction loans modified in troubled debt restructurings, almost 54 percent are now delinquent, in default or reclassified as non-accrual.
The Office of the Comptroller of the Currency’s most recent Survey of Credit Underwriting Practices shows a minority of banks is still tightening standards on commercial real estate construction loans. Most report holding the line on tighter standards established during 2009 and 2010. Outside the exclusive environs of New York and its peer markets, that suggests little relief for borrowers seeking access to financing.
Regulatory constraints on new construction lending are hardly surprising. The experience of the late 1980s and early 1990s, when concentrations in construction lending contributed to record bank failures, has not escaped institutional memory. Chandan Economic’s preliminary data for the third quarter show a predictable pattern that, in most cases, validates the OCC’s survey findings.
Owing to robust fundamentals and apartment investors’ bullish outlook, multifamily construction has set the pace of the development recovery. The availability of construction-to-perm financing through life companies has facilitated some larger projects—in Manhattan, Brooklyn and elsewhere—with lower-risk profiles but higher absolute funding requirements. On more favorable terms to the borrower, Federal Housing Administration financing has been critical to the broader multifamily trend.
Rental construction starts jumped 60 percent between 2010 and 2011. That momentum shows little sign of easing, with starts in the first half of 2012 rising another 44 percent. The force of the development pipeline has yet to reach the market. Completions began to trend higher in the second quarter, heralding sharper increases over the next two years.
Data from the Commerce Department show private sector construction spending was up 15 percent in July 2012 as compared to a year earlier. That increase reflects a near 50 percent jump in nominal spending on new multifamily assets. But it also captures surprising improvements in the retail and hotel sectors. As frenzied as the pace of hotel development is in New York, local outlays cannot fully account for the national result. From their very low levels, the second and third quarters’ data show observable increases in construction activity and related financing for these other property types, albeit on terms and with structures that are markedly more conservative than for apartments.
Outpacing national investment trends, New York’s condominium, rental apartment and trophy office markets are still early into the development boom heralded by large-scale projects and their financing announcements. Asset prices are high enough at the best locations that development lending is a viable option for risk-tolerant institutions. The trend is most apparent in the condo market but has translated into a deeper pipeline for office and hotel assets as well.
If market average occupancy rates were the decisive metric, some of the most visible projects would not get underway. The developers of new space are unlikely to bear the brunt of higher vacancy rates implied by the introduction of new inventory ahead of strong jobs numbers. Given the relative age of New York’s property base, historical trends suggest that tenants will gravitate to the newer properties, with older and functionally obsolete stock suffering the negative impact of tenant migration. For lenders on the new projects, that migration may be of little concern. For incumbent lenders, the risks should be given due consideration.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at dsc@chandan.com.
