Banks have traditionally been the go-to source for construction loans. But they may lose some of that edge in an increasingly competitive marketplace that is filling up with non-bank lenders, as well as a tougher regulatory environment that will make banks “think twice” about issuing construction loans.
The construction cranes that are once again popping up on city skylines have marked the return of commercial development activity. Total construction starts through the first four months of 2015, including both residential and non-residential projects, totaled $208.2 billion, according to Dodge Data & Analytics. That volume represents a 24 percent jump compared to the same period a year ago. The growing development pipeline is sparking lender interest from both old and new capital sources.
Although many banks returned to construction lending early in 2010 and 2011, small and mid-size banks are now accelerating their activity. Non-bank financial institutions, such as mortgage REITs, private equity funds and foreign capital, have also become more active in providing construction loans, particularly for higher leverage deals.
“If you’re a developer, there are clearly more sources of construction financing developing beyond the traditional banks in the non-bank financial institutions,” says Marc McAndrew, executive vice president and head of real estate banking at PNC Bank N.A.
Even life insurance companies are stepping in to do more construction loans. Prudential Mortgage Capital Company is one firm that has seen a spike in its construction lending through FHA, Fannie Mae and Freddie Mac programs. For example, in its FHA loan program alone Prudential’s pipeline has gone from construction or refinancing loans representing 30 percent of the loan volume to 50 percent over the last year.
“We made a decision to increase our exposure in new construction about a year ago. So we are starting to now see that come through,” says Patrick Kempton, a principal with Prudential Mortgage.
Yet as more lenders expand their construction lending pipelines, some banks are actually tightening the reins on construction lending in light of the competition and new regulatory changes. “From our perspective, we would expect to do slightly less construction lending in 2015 than 2014, and that is not because there is less construction activity,” says McAndrew.
Although PNC remains one of the leading construction lenders in the country, the forecast decline is due in part to the increased competition in the market, as well PNC’s assessment of the risk versus return picture. PNC was one of the early lenders out of the gate doing construction lending in 2010 and 2011. “So we don’t need to catch up, and we are really sticking to our underwriting standards and quality standards,” McAndrew says.
He declined to disclose specific numbers, but describes PNC as having a “very healthy” construction book. “It is not that we want our volume to be down, but we’re not following the market from price and structure standpoint, particularly as it relates to construction.”
On the books
New regulatory requirements for banks will also be a factor in their willingness to do construction loans. The regulations apply specifically to high volatility commercial real estate (HVCRE) loans. In the past, banks had to hold 8 percent capital against those HVCRE loans, which would include construction loans. Now that requirement has increased by 1.5 times to 12 percent.
‘Banks are definitely being incentivized away from construction lending by capital and liquidity regulation,” says Christina Zausner, vice president, policy and industry analysis, at the CRE Finance Council in Washington, D.C. That is not to say that banks do not have the desire or the capacity to make construction loans. However, they are having to adjust some of their underwriting and pricing parameters because of the regulations. In addition, they are syndicating loans more proactively, adds Zausner.
The regulatory change is likely to be a factor in banks’ appetite for construction loans going forward. “It is certainly causing people to think more about how they deploy their construction capital, and it will [make] the deployment of that capital slightly more expensive,” says McAndrew. “So that will probably have an impact on pricing over time.”
Banks started reporting on HVCRE in the first quarter 2015. However, there are still a lot of questions in the banking industry regarding how those regulations will be interpreted. It could take a year for some of those questions to be resolved.
Even if banks do pull back on construction lending, there are plenty of players willing to step in and fill that gap. The best borrowers and properties can pretty much name their lender as there is strong demand from non-bank options, such as life companies, private equity groups and mortgage REITs. However, borrowers with weaker credit have far fewer options. Those at the bottom of the stack and developers in secondary and tertiary markets are having to seek out more unconventional financing, such as private partnerships or LLCs, says Zausner.