The (Improving) State of Construction Lending
Construction lending has registered a marked improvement over the last six months, in top-rung metro areas and increasingly in secondary markets as well. During the financial crisis and for most of the period that has followed, development financing has been reserved for the most rarefied opportunities. With the exception of the apartment sector, the search for new projects has generally brought us back to New York and the other cardinal metros. Eager developers chancing upon opportunities elsewhere have found themselves hamstrung by hesitancy among potential anchors, reluctant banks and skeptical regulators. That is changing.
Commensurate with a moribund recovery in the economy and labor market, underwriting standards for construction loans remain relatively conservative. Lenders report holding to their demanding criteria; the prevailing view is that development backing has broadened to a wider range of projects and locations only as demand from borrowers deemed well qualified has firmed. Chandan Economics’s tally of first-quarter 2013 construction loan data shows this is true in part but not in whole. Lenders are inching out on the risk spectrum, albeit in ways that are mitigated by fundamentals and investment trends.
Not unreasonably, a profit motive is at work in the construction finance turnaround. And not unlike investors on the hunt for yield, unexceptional returns on stabilized lending in the apartment sector have added to the attractiveness of riskier commitments. Higher loan-to-cost ratios and less-demanding guarantees are both features of a thawing market, as are rising prices for development sites. On the margins, non-recourse lending and speculative development are not as rare as they were a year ago.
Among the findings from our most recent analysis:
• From a third-quarter 2008 peak of $472 billion in multifamily and commercial property construction loans, banks’ exposure has fallen by almost 60 percent. Banks’ net lending declined by more than $4 billion in the fourth quarter of 2012, but gross lending on commercial projects is rising.
• The default rate on banks’ commercial construction loans, which includes a broader set than the industry definition, has fallen from a crisis peak of more than 15 percent to 8.6 percent. The lower default rate is correlated with the uptick in lending; both derive from an improving market. But it also exhibits a causal relationship with lending, through the channel of supervisory relationships.
• The most recent survey of underwriting by the comptroller of the currency, dating back to last June, shows all but a small minority of banks holding or tightening standards on construction lending. That survey result was generally consistent with loan-level analysis through the third quarter of 2012. It is not supported by the analysis of activity in subsequent quarters.
• Multifamily financing activity is tracking the surge in development activity. The rental apartment share of multifamily construction has peaked, however, at a cyclical high of more than 90 percent. That contrasts with nearly a 50 percent share of multifamily activity at the peak of the condo-development cycle.
• The increase in speculative construction projects where there is no significant pre-leasing is concentrated in the industrial sector, particularly in logistics. There is virtually no spec construction in the retail sector.
• Financing of very large projects shows little consistency in leverage or capital sources. Apart from the most visible projects in Manhattan, bank syndicates have been more active in financing major projects in other large markets.
• Rising CMBS activity will enlarge the overlap between conduits and banks for performing assets. A loss of market share by banks will raise pressure to lend against development and construction projects.
• New construction with specific objectives for green certification shows marginally lower borrowing costs, measured in terms of rate spreads. Because of the strong correlation between project scale, location, subjective measures of sponsorship quality and stated certification objectives, a causal relationship between intended certification and borrowing costs cannot be disentangled.
Heading into the summer, the credit quality of the median construction loan remains within tolerance. The scrutiny with which lenders have re-engaged on this front bears little resemblance to the complacency that is increasingly endemic to lending for multifamily properties and construction. Some measure of tail risk is inevitably a feature of construction lending. Apart from project-specific dimensions of risk-taking, including loan-to-cost, the extent of recourse and pre-leasing, the downside possibility of an interest rate spike that coincides with takeout financing is increasingly relevant market-wide.
Market incumbents should remain attentive to development trends, even if resilient assets dominate their lending and investment portfolios. After more than a decade of relatively subdued construction activity, financing in several markets is premised increasingly on the age and functional or aesthetic obsolescence of the inventory. The underwriting calculus anticipates new construction displacing older properties. In markets with slow endogenous growth in tenancy, those older properties will bear the brunt of lower market occupancy rates and pressure on fundamentals.
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 firstname.lastname@example.org.