CREFW-Fall2015

CRE Finance World Autumn 2015

Risk Management and Loan Administration for the Next Generation of Commercial Construction Lenders

Stacy Berger

Executive Vice President

Midland Loan Services, a PNC Real

Estate Business

ommercial and multifamily construction lending activity

has significantly increased in volume since its nadir

concurrent with the economic downturn commonly

referred to as the Great Recession. The commercial real

estate industry has recovered, and the fundamental

demand drivers for new construction are strong. However

construction lending by commercial banks has become more

challenging as regulatory changes now require banks to hold more

capital against many types of construction loans. New sources

of capital are developing, and a new paradigm for construction

lending is emerging. Non-traditional construction lenders such as

life insurance companies, specialty finance companies and REIT’s,

are funding new commercial and multifamily construction projects.

Many of these lenders are using third party construction loan

administrators to manage the risk inherent with construction

lending instead of building the requisite resources and

infrastructure in-house.

Construction lending has historically been the province of

commercial banks. Construction loans are the cornerstone of

bank real estate lending activities. Community and regional

banks extend construction loans to local developers; national

banks lend on larger projects, and the largest developments are

typically financed through bank syndicates. Banks provide the

short-term, floating rate financing and associated construction

loan administration through completion of the project, lease-up

and stabilization. On project completion and stabilization, portfolio

lenders or issuers of commercial mortgage-backed securities

provide the permanent fixed-rate financing.

Total commercial construction activity (excluding public works

and infrastructure) has recovered from the declines associated

with the economic recession starting in 2007. Total commercial

construction start activity peaked in 2007 at $300 billion in

volume. By 2011, construction start volume had declined by 38

percent from its peak to $186 billion. Volume is projected to

approach $280 billion in 2015 (source: McGraw Hill Construction

Research and Analytics).

Commercial construction is fundamentally a local activity. The

economic drivers of commercial and multifamily construction vary

by property type and include occupancy, rental income growth,

retail sales, housing starts, household formation and other factors.

Generally, these factors have been trending positively in many

local markets and are generating new construction starts. The

American Institute of Architects projects the average of all non-

residential construction activity to increase by 7.7 percent in 2015

and 8.2 percent during 2016. Of the total commercial construction,

approximately $60-70 billion annually may be funded through non-

bank lenders.

The implementation of Basel III capital rules has had a negative

impact on the availability and cost of construction lending by

commercial banks. Specifically the High Volatility Commercial

Real Estate (HVCRE) regulations have increased the regulatory

capital required for banks to hold against real estate construction

lending activity, and made certain higher leverage or speculative

construction lending activities prohibitively expensive. These

regulations have increased the equity required from developers

and limited the contribution of appreciated land to fulfill this equity

requirement. This disruption in commercial bank construction

lending activity is creating opportunities for non-regulated lenders

to increase their market share in the sector. These lenders are

seeking the higher yields associated with construction lending,

as well as the opportunity to place permanent loans on the

completed projects.

During the past economic downturn, portfolio lenders were

opportunistic in providing permanent loans on high quality assets.

Currently insurance companies have been aggressive in bidding

for well-located, institutional grade properties with strong tenants

and sponsors. Portfolio lenders and specialty finance companies

have been very competitive on permanent loans secured by

properties net leased to high quality tenants including the federal

government, healthcare and academic institutions. Loans on

institutional-quality multifamily properties and properties leased

to investment grade rated tenants are also in high demand.

Specialty finance companies have also emerged to provide

financing for smaller commercial construction projects.

To secure these permanent loans, life insurance companies and

specialty finance companies are offering combined construction/

permanent loans. Developers find this type of construction/

permanent loan an attractive alternative to finance their properties.

Borrowers can take advantage of today’s low interest rate

environment by locking in attractive financing and realizing the

efficiencies of a single negotiation and loan closing. They also limit

their risks associated with having to secure permanent financing

in an uncertain future market environment. Mortgage bankers are

finding opportunities to represent borrowers and to place these

types of construction/permanent loans with their portfolio lending

relationships. In many cases, these non-bank lenders lack the

internal expertise and resources and use third party construction

loan administrators to support this activity and to manage the

financial risk associated with the construction financing.

Third party construction loan administrators provide an efficient

and effective means of risk management and project financial

oversight for lenders who do not have the in-house resources

and capabilities to offer construction loans. This construct

provides the lender with the expertise and resources to manage