The rumors and anecdotes you have heard about difficulties securing construction financing are true – banks are significantly curtailing their construction loan allocations and tightening their lending requirements, signaling a shift in how development deals might get financed going forward. Banks are citing new regulations as reasons for this pullback, but these regulations have been in place for years. Why the sudden change?
After speaking with several bankers, the answer appears to be a combination of two factors – a weariness of the high volume, low margin construction lending business model, and a desire to avoid overbuilding in already saturated markets.
The two regulations commercial real estate bankers most often cite as reasons for the slowdown in construction financing are the Basel III Liquidity Coverage Ratio (LQR) and the High Velocity Commercial Real Estate (HVCRE) requirements. The LQR requirements took effect in January 2013, and generally speaking, require banks to hold more capital on their balance sheet for commercial real estate loans. The HVCRE provisions took effect in January 2015 and require banks to reserve 50% more capital on their balance sheet for construction loans where either the Borrower’s contributed equity is less than 15% of appraised value “at completion”, or the Borrower wishes to distribute excess cash flow to its equity partners prior to selling the property or converting the loan to permanent financing.
When a bank is required to keep more capital on its balance sheet it directly impacts the cost of capital for potential borrowers. However, the banks’ higher cost of capital as a result of LQR and HVCRE were not immediately passed on to borrowers in 2013 and 2015, respectively.
In 2013, many markets around the country were entering the growth stage in the real estate cycle and construction activity was strong. Individual banks did not want to lose business to their competitors and were eager to lend. As a result, spreads on construction loans remained low (1 Month LIBOR +150-200 bps, for example) and banks turned to a volume model to make up for the lower yield on each loan.
When HVCRE took effect in January 2015, banks were again slow to pass costs along to Borrowers. The implementation of the regulations and the specific fines and penalties for not following the requirements were not immediately clear, and as a result, banks were free to interpret regulations as they saw fit, and in some cases, ignore them all together.
As we approach the third quarter of 2016, it is apparent that banks are now passing along the higher capital costs to their Borrowers. Spreads on construction loans have expanded 50-150 bps in the last six months and banks are often reserving their construction loan allocations for their longest-tenured, highest priority relationships. What has changed that was not apparent before?
In interviews with CRE bankers across the country, it became clear that banks are curtailing construction lending because the low price, high volume business model was not very profitable, and they feel the timing is right to regain pricing power after years of diminishing returns. Low-priced construction loans pose a problem for the banks because the terms of the loans are shorter (typically five years or less), the interest rate spreads are lower than permanent loans, and the loans are usually prepaid early at stabilization due to a sale or refinance. A bank does not begin earning interest on a loan until all the equity is in the deal so a construction loan balance builds slowly over time, and a bank only begins to earn its maximum revenue when the loan is fully funded and construction is completed.
Compounding the problem is that once completed, a Borrower is often motivated to take out its construction loan with a low fixed rate permanent loan from a life company. This further erodes the bank’s profitability as they are unable to earn the higher interest revenue built into the later months of a loan. For this reason, several banks are eliminating their construction loan allocations for all but their most trusted, longest-tenured borrowers, with whom they have deposit relationships with. If construction lending isn’t the most profitable line of business, banks want to reserve funds for those customers that generate revenue for the bank in other ways.
Several bankers we spoke to also sense that we are entering the later stages of the current real estate cycle, and they do not want to contribute to the overbuilding of some product types in specific markets - the prime example being the fear of overbuilding apartments in Denver. Armed with this justification, banks finally feel they have the power to increase loan spreads and accurately reflect the true cost of construction lending. By simultaneously curtailing loan volume to combat overbuilding, they may also reduce the severity of a future downturn if and when it occurs.
Looking to the future, a significant drop in bank-issued construction financing could create an opportunity for those life insurance companies and debt funds with construction loan programs to grab a larger share of the market and create greater yields for their investors in the second half of this year. However, given their aggressive funding allocations to-date, it remains to be seen if insurance companies and debt funds have enough capital on hand to meet the coming demand, or if the slowdown in construction lending will help prolong the current real estate cycle by acting as a governor on the pace of development.