Western Real Estate Business

OCT 2016

Western Real Estate Business magazine covers the multifamily, retail, office, healthcare, industrial and hospitality sectors in the Western United States.

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36 • October 2016 • Western Real Estate Business www.REBusinessOnline.com SLOW FOR CONSTRUCTION The construction lending industry has downshifted, creating significant implications for developers. By Kevin Choquette D evelopers, like all entrepreneurs, are great problem solvers. Problems of all varieties occur, and while efficient access to accretive debt financing won't rate as one of Donald Rumsfeld's "unknown, unknowns," the re- cent challenges associated with securing a construction loan have had, and will continue to have, significant impacts on the developer. What Happened? There are many questions that abound as we start to find some stride in the recovery, especially on the development side, but then witness a reduction in construction lending. Chief among them are: why the sudden slowdown in construction lending? Why, prior to an increase in defaults, prior to a recession, prior to a major macro-economic event (all of which would have lenders pump the brakes) are we experiencing a slow down? Isn't this the time in the cycle where lenders typically loosen up, gain some confidence in the cycle, and com- pete by loosening their underwriting standards to secure some of the limited number of vibrant construction loan opportunities in the market? Yes. That's how it usually goes. Just The Facts Ma'am Aside from all of the discussion about a slowdown in construction lending, and anecdotal evidence of the same, it is important to realize that the long-term trend is good. Look at the FDIC data showing construction loans on balance sheet, nominally as well as in year-over-year percentage terms. Clearly, things are moving in the right direction. However, banks' total construction exposure was only $266.1 billion in the third quarter of 2015, a far cry from the 2008 peak of $626.5 billion. While the trend is good, and we would argue this is a good time to make construction loans as many assets are trading well above replacement cost, storm clouds are on the horizon. A Complex Low-Pressure System As a surfer and skier, I look at weather in much greater detail than the aver- age person. A complex low has several low pressure centers and can behave unpredictably with uncertain winds and precipitation, as well as an uncertain path. The storm in construction lending, if you will, resembles a complex low with the three lows coming from: • Basel III • Dodd Frank • Consumer Protection Agency The "storm" has been off the coast for over a year and only recently, having percolated through the regulatory framework of the lending community, has it made landfall. Basel III hit the books in January 2015. This regulation defined most acquisition, development, and construction loans (AD&C) as requiring 150 percent of the typical capital reserves. It also requires 15 percent of the com- pleted value of the project to be funded with cash, not imputed land equity. The implications on banks' capital ratios, depending upon their portfolio composi- tion, can be significant. Many of the banks prepared for the storm at the first indications of trouble, changing their approach to construction lending as soon as the regulations came into effect. Others have tried to call the storm's bluff, refusing to adopt or not choosing to adopt yet, any policies which accommo- date the changes. The Storm Makes Landfall With a November letter from the Fed, the storm made landfall. The Fed's message: be careful as competition rises. Their letter may be well summed up with this statement, in typical Fed speak: "In light of the developments mentioned above, financial institutions should review their policies and practices related to CRE lending and should main- tain risk management practices and capital levels commensurate with the level and nature of their CRE concentration risk. In particular, financial institutions should maintain underwriting discipline and exercise prudent risk manage- ment practices that identify, measure, monitor, and manage the risks arising from their CRE lending activity." While that alone isn't directly impacting the construction lending, increased regulatory oversight and audits on banks, with a rigorous focus on High Vola- tility Commercial Real Estate (HVCRE) has had a clear impact on lenders and they are seeking shelter by tightening credit standards and lowering advance rates. While not explicitly stated, many in the industry are of the opinion that the Fed/regulators are indicating that construction lending is not a product well suited to regulated banks. The underlying message may be that the shad- ow banking system should provide a natural home for construction lending activity. EXHIBITS The following two exhibits from the Fed provide some clear evidence of the pull back (emphasis added). Over the past three months, how have your bank's credit standards for ap- proving new applications for construction and land development loans or cred- it lines changed? Choquette Source: FDIC, Call Reports, Chandan; In Billions Quarterly Change in Construction Loans Held on Bank Balance Sheets Source: FDIC, Call Reports, Chandan; In Billions YoY Percent Change in Construction Loans Held on Bank Balance Sheets All Respondents Large Banks Other Banks Banks Percent Banks Percent Banks Percent Tightened Considerably 2 2.9 2 4.9 0 0.0 Tightened somewhat 15 21.7 12 29.3 3 10.7 Remained Basically Unchanged 52 75.4 27 65.9 25 89.3 Eased Somewhat 0 0.0 0 0.0 0 0.0 Eased Considerably 0 0.0 0 0.0 0 0.0 Total 69 100.0 41 100.0 28 100.0

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