Constructing Lending Grows Faster Than Traditional Loans
NEW YORK CITY—Here is an interesting factoid about the commercial real estate bank lending market: Currently bank lending for construction and development is growing faster than lending for completed buildings, according to a soon-to-be released independent analysis by Chandan Economics of call reports filed by banks with the Federal Deposit Insurance Corp.
This is in marked contrast with recent history, Sam Chandan, president and Chief Economist of Chandan Economics and an adjunct professor in real estate and public policy at the Wharton School of the University of Pennsylvania, tells GlobeSt.com. "Over the last year," he says, "the balance of construction loans held by banks has grown by nearly 15%."
That compares to a 4.1% growth of commercial loans on bank balance sheets from Q1 2014 to Q1 2015 and a 12.4% increase of multifamily loans during the same time period.
It is little secret that bank lending for commercial real estate has largely recovered from the recession. But the stepped up pace of construction lending is a new twist, and very illustrative. Even as signs mount that the current cycle is well into the latter stages and the US economy may or may not be faltering, banks continue to pursue the real estate asset class, including riskier development activity.
The ever-declining default rates have much to do with this trend.
According to Chandan Economics' analysis of the call reports, the default rate for banks' multifamily and commercial real estate mortgages declined to 1% during the first quarter, down 10 basis points (give or take) from 1.1% during Q4 2014 and down 60 basis points from a year earlier during Q1 2014. It is the 18th consecutive quarter that the default rate for banks' multifamily and commercial real estate mortgages has declined, following its peak at 4.4% in Q3 2010.
In addition, the default rate for banks' multifamily mortgages was essentially unchanged from Q4 2014 to Q1 2015, at 0.4% -- the lowest default rate since 2006, before the market peaked.
For construction loans, the default rate was 1.8% in the first quarter, the lowest level since Q2 2007 and just a fraction of the 16.8% peak five years ago. In short, banks have largely cleared the bulk of legacy construction loans from their balance sheets.
Lending, meanwhile, continues on its upward trajectory, the figures from Chandan's analysis show.
"Banks continued to grow their exposure to commercial real estate at a measured pace during the first quarter," Chandan says.
Of course always present in the background is the question of whether banks are taking on more risk than they should. Competition for high quality lending opportunities is intense, Chandan points out, and "a range of data sources suggests that slowly improving property fundamentals combined with easing lending standards have widened the pool of prospective borrowers."
Ditto for construction lending. "Setting aside transformative, large-scale development projects in the largest markets, we expect that bank funding for more small- and mid-cap property development will trend higher as conditions in secondary markets support new inventory," Chandan continues.
The inevitable result of this competition is the presence of less-than-top-quality loans on the balance sheet. Chandan says banks' newest multifamily loans are a source of concern and that competition among lenders -- fueled by differences in their underlying costs of capital -- has encouraged laxity in underwriting standards and loan structures.
"The notion of a borrower's market is problematic," he says. "From a risk management perspective, the current dynamic on the debt side bears some resemblance to the residential borrower's market of a decade ago."
But for the most part the industry appears to have absorbed the painful lessons of the recession and the events leading up to it. For instance, there is a chance that construction lending could slow its current heady pace, Chandan says, with the category's higher risk weights possibly proving to be a headwind for bank funding of development.
The CMBS market is shored up too, which helps.
"While the CMBS market will see its last waves of pre-crisis vintages mature over the next couple of years, post-crisis lending on generally more conservative terms dominates the bank profile," Chandan says.