The first six months of 2016 have seen interest rates for commercial real estate dip to record lows, which has driven an uptick in refinance activity across all property types. Life insurance companies have been the primary source of capital for most investors, as CMBS issuance has yet to catch up to the pace set in 2015. Year-to-date CMBS issuance is currently less than 60% of 2015 levels. As a result, life insurance companies are close to reaching their 2016 funding targets, with many reporting that they have committed or closed more than 80% of their 2016 allocation.
A similar trend has emerged in bank-issued construction financing. Several of Essex’s primary money-center and regional bank lenders have indicated that the first half of 2016 saw a robust issuance of construction loans for all major property types, as these loans provided greater yields than long-term permanent loans. This trend is not expected to continue, however, as government regulations such as Dodd-Frank’s high volatility commercial real estate (HVCRE) loan provision begin to take effect. The HVCRE provision requires a bank to hold 50% more cash reserves on its balance sheet for construction loans. As these banks begin to look at their ability to fund additional construction loans in the second half of 2016, many are choosing to dramatically curtail their loan originations for all but their most trusted, longest-tenured clients with existing deposit relationships due to the combination of HVCRE provisions and where they feel we are in the current real estate cycle. Essex has been surprised to learn that some of its large, well-funded developer clients have been turned down for bank-issued construction financing in the past few months despite a conservative loan request and a willingness to provide a repayment guaranty.
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 life 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.