Last week Rabbet sponsored the Mortgage Banker’s Association’s “Bank CRE Lending Report & CREF Ecosystem Outlook”. During which a panelist from a major US bank purported that construction lending is currently “safer” than stabilized assets.
Historically, construction lending is the riskiest undertaking that a bank engages in according to the Office of the Comptroller of Currency. This is largely because it is the only collateral that a bank secures a loan against that is being constructed with the proceeds of the lending. Stated another way, the securitization of the loan doesn’t exist until the loan funds are disbursed and implemented properly.
Therein, the panelist’s statement that construction lending is less risky in the current environment when compared to stabilized real estate lending is a fairly monumental claim. What is the backdrop for the current assessment?
Pros for Construction
- They have built-in interest reserves.
- Regulators have no current reason to force them to be downgraded.
- Tons of equity coming in.
Cons for Stabilized
- Hotels are closed.
- Multi-family has deferrals and eviction moratoriums.
- Offices are not being leased.
- The choppiness of the takeout market.
- Regulators are stating that if a property cannot be stabilized within a year, it must be downgraded.
The argument can be boiled down into a statement that it is easier to predict cash flows in three years than it is to predict cash flows in six months. This in and of itself is not much of a bold claim. It is certainly much easier to predict generally a retrenchment of the “pre-pandemic environment” in two years than it is for next year with all the current uncertainty.
That said, to state that the confidence around cash flows in three years makes construction less risky was a question I had to get more insight on.
A Panel of Experts to Discuss
Thursday we convened a panel of experts that oversee over $100B of construction lending at 10 of the top financial institutions in the US. And I posed them this same question.
“Is construction lending currently less risky for your financial institution than stabilized lending?”
The response was exactly what you’d expect from a panel of bankers. “Well, it depends”.
And it certainly does. A stabilized industrial park with 10 year leases with Amazon is certainly much less risky than a ground-up hotel. But reverse that a little, and a group-up industrial park is much less risky than a “stabilized” hotel.
Taking out the huge variation for product type and geography, the panel was relatively in agreement that construction risk and buying the three years to stabilize the economy, the pandemic, etc. is less risky than a stabilized asset today that has uncertain cash flows and no reserves for the next six months. With the notable exception of industrial, almost every other product type (office, hotel, multi-family, retail, etc.) appeared easier to predict three years into the future than six months into the future.
Trey Meers from Wintrust Financial put it fairly concisely, “Here in Chicago, multi-family has generally been rock solid and it’s still is fairly stable. However, there are concerns about how people’s behavior will be affected even after the vaccine rolls out. We don’t know what they’ll be comfortable with. There’s confidence that people will be back in those markets in two years, but it’s unclear what it will look like between now and then.”
A Huge Exception
The panel brought up one very notable exception. Construction costs.
With the continued toll of the economy and supply chains, construction costs have been very hard to predict over the last six months. One panelist noted that every one of their projects had a change order on framing over the last six months. And these costs are still very hard to predict.
This uncertainty around costs still makes construction lending a more difficult lending market than it was a year ago. Additionally, like all good portfolio construction, the panel felt that balance of their portfolio was still important even if they are currently seeing better opportunities in construction.
Safer is Relative
In conclusion, most all real estate lending is risky right now. And as with all lending, future cash flows are key to determine the ability of the borrower to repay the loan. The predictability of those cash flows is extremely difficult right now but may be slightly more predictable in three years that would encourage construction lending as a marginally better investment for a financial institution at this time.
Therein the “risk premium” for construction is lower now than normal. The term “safe harbor” is misleading with construction having extensive inherent risks, but the near-term economic uncertainty makes it a good time to have an asset coming online in a year or two instead of today.
