Page 24 —
COLORADO REAL ESTATE JOURNAL
— September 21-October 4, 2016
Finance
T
he rumors and anec-
dotes you have heard
about difficulties secur-
ing construction financing are
true – banks are significantly
curtailing their construction loan
allocations and tightening their
lending requirements, signal-
ing 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 bank-
ers, the answer appears to be a
combination of two factors – a
weariness of the high-volume,
low-margin construction lend-
ing business model and a desire
to avoid overbuilding in already
saturated markets.
The two regulations commer-
cial real estate bankers most
often cite as reasons for the slow-
down in construction financing
are the Basel III Liquidity Cover-
age Ratio and the High Velocity
Commercial Real Estate require-
ments. The LQR requirements
took effect in January 2013 and
generally speaking require banks
to hold more capital on their
balance sheets for commercial
real estate loans. The HVCRE
provisions took effect in Janu-
ary 2015 and require banks to
reserve 50 percent more capital
on their balance sheets for con-
struction loans where either the
borrower’s contributed equity is
less than 15 percent of appraised
value “at completion,” or the
b o r r o w e r
wishes to dis-
tribute excess
cash
flow
to its equity
partners prior
to selling the
property or
c onv e r t i ng
the loan to
p e rma n e n t
financing.
W h e n
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 andwere eager
to lend. As a result, spreads on
construction loans remained low
(one-month LIBOR plus 150 to
200 basis points, 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 bor-
rowers. The implementation of
the regulations and the specific
fines and penalties for not fol-
lowing the requirements were
not immediately clear, and as a
result, banks were free to inter-
pret regulations as they saw fit
and, in some cases, ignore them
all together.
Aswe approach the third quar-
ter of 2016, it is apparent that
banks are now passing along the
higher capital costs to their bor-
rowers. Spreads on construction
loans have expanded 50 to 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 bank-
ers 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 pre-
paid 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 con-
struction is completed.
Compounding the problem
is that once completed, a bor-
rower 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
it was unable to earn the higher
interest revenue built into the
later months of a loan. For this
reason, several banks are elimi-
nating their construction loan
allocations for all but their most
trusted, longest-tenured bor-
rowers, with whom they have
deposit relationships. If con-
struction 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 over-
building of some product types
in specific markets – the prime
example being the fear of over-
building 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 sever-
ity of a future downturn if and
when it occurs.
Looking to the future, a sig-
nificant 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 lend-
ing will help prolong the current
real estate cycle by acting as a
governor on the pace of devel-
opment.
s
Jared Wiedmeyer
Real estate analyst,
Essex Financial Group,
Denver
As we
approach the
third quarter
of 2016, it is
apparent that
banks are now
passing along
the higher
capital costs
to their
borrowers.
