Securing bank construction loans has become a tough nut for developers to crack. Some banks have pulled back on allocations to new development, while banks across the board have become more conservative in deploying that capital.
Over the past two years, banks wary of taking on construction risk have lowered leverage, increased rates, applied more conservative underwriting and become more selective on borrowers and deals. And that picture isn’t likely to change anytime soon. “When we hear people complaining about banks lending for construction, I think it is really that they are bringing in the leverage and they are pricing it a little bit wider than they were a year ago,” says Joe Franzetti, a senior vice president at Berkadia Commercial Mortgage.
On average, loan-to-cost amounts have dropped 5 to 10 percent, with leverage on high quality loans typically at 65 percent, notes Franzetti. Banks have also raised rates slightly as they have become more selective, with pricing that is 50 to 100 basis points higher as compared to two or three years ago.
“Bank involvement in construction lending for the past two to three years has been disciplined,” adds Norm Nichols, executive vice president and head of the Income Property Group, KeyBank Real Estate Capital. Most banks of any scale are saving construction allocations for their best clients where they can be the lead versus putting capital into someone else’s deal, notes Nichols.
Banks are closely managing construction loan allocations, partly due to High-Volatility Commercial Real Estate (HVCRE) rules, which require all loans that meet that definition be reported separately and assigned a risk weighting of 150 percent for risk-based capital purposes. Banks are also more conservative because they recognize that the market is moving into the later stages of the real estate cycle, and some sectors and submarkets could face challenges due to slower growth, leasing challenges or even oversupply.
Banks wary of new supply
Multifamily developers have felt the brunt of the pullback in construction lending as that sector has seen the most development activity. PNC Real Estate is one bank that has admittedly “taken its foot off the gas” on its multifamily construction lending, notes David Aloise, an executive vice president at PNC Real Estate.
PNC returned to the multifamily construction market early in 2011, and in late 2015, the bank made a strategic decision to reduce construction loans to multifamily projects. Its construction lending subsequently dropped by about 25 to 30 percent in 2016 and has maintained a similar pace in 2017. “That was partly due to the size of our construction portfolio, which had grown pretty dramatically over that time period,” says Aloise. The bank’s high concentration in multifamily was also a factor as apartment deals account for about three-fourths of all of the bank’s construction lending.
“We may have been a little bit earlier than some of our competitors in making that determination, but I think a lot of banks in 2016 made similar choices and became increasingly selective and more focused on submarket fundamentals,” says Aloise. “Clearly, we have seen a deceleration of rent growth across most markets and there have been pockets of supply issues.”
Some banks are requiring 30 to 40 percent equity on apartment construction loans, as well as using disciplined underwriting related to vacancy and factoring in concessions during the lease-up period, notes Nichols. After a steady flow of new supply in recent years, the peak years for national apartment construction are likely to be 2017 and 2018. “I think discipline stems from the fact that that supply surge is ahead of us, and there is a fair amount of uncertainty on how, at least in some markets, all of this supply is going to be absorbed,” he says.
Banks still have a healthy appetite for construction loans on industrial, build-to-suit projects and significantly pre-leased office projects, while speculative office and retail construction loans are more challenging. Retail in particular is in the hot seat. Bankers are wary of the potential negative impacts from e-commerce and weaker retailer credit. “There is no doubt that retail is under duress from that perspective, which raises the question of how much brick-and-mortar retail does a certain market need,” says Nichols.
That being said, retail lending is not going to zero. Some banks can get comfortable with retail by relying on more conservative underwriting and lowering leverage. “We’re really looking at the tenant composition of a center to try to get an understanding of how insulated those tenants are from e-commerce,” adds Nichols.
New high-volatility rules ahead?
The construction lending climate is likely to remain much the same in 2018. However, banks are continuing to watch how new apartment supply is absorbed. If fundamentals remain strong, it could boost confidence and banks may be more willing to make multifamily construction loans. Meanwhile, retail construction lending could become even more conservative in 2018, depending on how retailers are impacted by holiday sales and additional store closings and bankruptcies.
One issue to watch in 2018 is a new high volatility loan proposal (H.R. 2148) for High Volatility Acquisition, Development and Construction (HVADC). Essentially, the proposal creates an additional bucket of high volatility loans with a lower capital hold requirement or capital weighting of 130 percent versus 150 percent.
In its current form, the larger banks would be subject to both HVCRE and HVADC rules, while smaller banks would only have to comply with HVADC rules. “One of the things the industry has some concern about is whether this creates two classes of lenders in terms of capital weightings and how the playing field may change for larger and smaller banks going forward,” says Aloise.
The new proposal might be an indication that regulators recognize that HVCRE didn’t really achieve what they wanted to do, and they are trying to fix it with the new version, says Franzetti. However, the HVADC proposal could actually end up muddying the waters even more and creating added confusion, he adds. The HVADC loans would also be more broadly defined, meaning that it could potentially impact more loans.