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Banks Take a Step Back on Construction Loans

Banks Take a Step Back on Construction Loans

Construction lending is on the rise as development pipelines continue to expand across commercial and multifamily markets. Yet borrowers are working harder to access that capital.

The volume of commercial and multifamily construction loans put in place in January reached $311.3 billion based on total project value. That represents a 14.3 percent increase year-over-year and a 40.7 percent increase compared to January 2014, according to the Mortgage Bankers Association’s Commercial/Multifamily Quarterly Databook for fourth quarter 2015.

Although there is still plenty of construction lending occurring, the overall appetite for construction lending has “dialed back a notch” among banks, says John Petrovski, head of U.S. commercial real estate at BMO Harris Bank. The backdrop to that pullback is that the real estate recovery is now getting a bit “long in the tooth” and is moving closer to a cyclical downturn, Petrovski notes. In addition, there are some concerns that the volume of new supply in some markets may outstrip demand in the short term, which could lead to rent concessions and some softening in fundamentals.

Banks are being more selective in their transactions. In addition, over the course of the last nine months—and even more acutely over the last six—the amounts on loan-to-construction values have tightened and the availability of construction financing for new borrowers has diminished. That shift is due to bank concerns about the maturing market cycle and concentration risk in particular geographic markets or product types. Some banks are also more conservative in their construction lending due to new Basel III rules now in place.

Banks have pulled back 5 to 10 percent on loan amounts based on loan-to-cost. A year ago, it was not unusual to see a construction loan committed at 70 to 75 percent loan-to-cost. That same loan today is probably at 60 to 65 percent, and in some cases even less, says Mark Strauss, a partner and managing director at Cohen Financial, a commercial debt and equity originator. The exception to that is that larger developers are able to leverage long-standing bank relationships to better access capital. “The banks are still reserving some dry powder or capital for those borrowers, whereas it is much more difficult for a new borrower in today’s part of the cycle to secure construction financing,” Strauss says.

Some banks are tightening construction lending in order to avoid having their transactions classified as high volatility commercial real estate (HVCRE) loans under new Basel III rules. The new rules require banks to hold 50 percent more cash reserves to account for anything that falls into the HVCRE category. For example, if a bank did a $4 million HVCRE loan in the past and had to hold $1 million in reserves against that loan, now the amount is $1.5 million. The new ruling applies to banks with greater than $500 million in assets and all savings and loan holding companies.

One stumbling block for developers related to HVCRE loans is a requirement that they put 15 percent equity into a deal based on completion value rather than cost. In the past, sponsors were able to use “land lift” or appreciated land value to count towards their equity stake. However, land lift has been virtually eliminated from any calculation of the equity and now land value is based on original cost. The 15 percent equity also has to stay in the transaction, until either refinancing or sale of the property, which means it can’t be diminished by cash distributions during lease-up.

Banks are also more sensitive to their construction lending exposure, or potential over-exposure, in certain geographic markets and property types. For example, publicly traded banks are ratcheting back their construction bucket in energy markets such as Texas just to show Wall Street that they are taking a more conservative view, says Jeff Zickefoose, an executive vice president at commercial real estate services firm JLL in Dallas.

Most banks are full on multifamily construction loans in particular. Three years ago, a borrower looking for an apartment construction loan could go to 50 banks and get seven or eight term sheets back with sufficient capital and competitive terms. About 12 to 18 months ago that number dropped to four or five and now it is at perhaps one to two choices for borrowers, says Zickefoose. Terms are not necessarily getting worse, but the amount of options for borrowers is shrinking, he says.

Apartment properties were the first sector to rebound in the wake of the recession and have generated the greatest velocity in terms of new construction. Much of that apartment construction has been concentrated in select markets. So bank lenders are looking very closely at apartment rents and concessions to see that projects are hitting their proforma targets before allocating more capital to those markets, says Strauss. “There is a caution among lenders to make sure that they don’t get ahead of themselves as they did in the period prior to 2007,” he notes.

Increased caution by the banks has opened the door for other players. Debt funds are stepping in to do construction loans, construction-to-permanent loans and bridge or mezzanine loans. Life companies are also willing to do construction loans. However, banks may open the purse strings wider on construction lending as some of the existing construction loans cycle through and move into permanent financing. “What we are hoping is that a lot of the construction is starting to finish up and will start selling in the market, which will start opening up the construction buckets,” says Zickefoose.

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