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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2016

Construction Lending Pulls Back

Apartment demand remains strong, but lenders are exercising restraint

In many cities across the country, cranes sprung up along the skyline and city blocks were cleared as apartment developers geared up their production efforts in the wake of the recession. This high level of construction activity foretold a spate of new deliveries that continue to hit the market.

Demand for these new units remains strong. Last year alone, a million more people became renters, and the number of renter households is up by some 5.8 million over the past five years.

Shifts in the construction-financing environment, however, may slow the industry’s progress going forward. Whether these changes will lead to a temporary pause in the flow of deliveries or a fundamental market change remains to be seen. For commercial mortgage brokers serving borrowers in the multifamily sector, the direction of future trends merits close attention.

Market metrics

In normal economic times, the apartment industry needs to deliver between 300,000 and 400,000 new apartment units annually to meet renter demand. The recession put a serious multiyear pinch on new apartment development, however, making the post-recession recovery period about not only getting back up to speed but also clawing out of a production deficit that began even before the recession. 

In 2015, the industry finally ramped up to meet the annual demand, delivering 310,300 new apartment units nationwide, according to U.S. Census Bureau data. The pipeline of new apartments remains solid for 2016, although multifamily permits are down slightly year over year. 

For this past third quarter, the most recent data available at press time, the U.S. Census Bureau reported that permits issued for multifamily units averaged 412,000 on a seasonally adjusted annual rate (SAAR), down 0.7 percent year over year. Multifamily starts over the same period decreased to 367,000 on a SAAR basis, down by 8.6 percent year over year. Similarly, completions averaged 283,300, down nearly 10 percent from the SAAR figure reported by the U.S. Census Bureau for third-quarter 2015.

Demand has more than kept pace with new apartment deliveries. Multifamily absorptions, a measure of the rate at which available units are rented, remain healthy. In fact, 65 percent of new units completed in fourth-quarter 2015 were rented within three months of completion, up from 59 percent in the final quarter of 2014, U.S. Census Bureau figures show.

Occupancy levels have remained high nationally as well, according to U.S. Census Bureau figures. The vacancy rate for all apartment rental units in third-quarter 2016 was 7.4 percent — the lowest third-quarter number in 33 years. MPF Research’s vacancy rate for investment-grade apartments tells of an even tighter market, with a 3.8 percent vacancy rate as of this past second quarter, the most recent data available.

Lending limitations

Despite the apartment market’s strong demand underpinnings, construction lenders are pulling back, raising borrowing costs, funding fewer loans and smaller loan-to-cost amounts, and also getting much more conservative in their underwriting. Two-thirds of those responding to the National Multifamily Housing Council’s Quarterly Survey of Apartment Conditions this past April reported less availability than six months ago. Additionally, almost three-quarters of those respondents reported that loan terms were less favorable. Industry executives also report that completion guarantees and even personal guarantees are becoming more commonplace.

As a result of the tightening regulatory conditions, lenders are
exercising a more cautious approach to construction lending.

So what are construction lenders seeing that is causing them to back off? First, they are seeing delivery levels return to more historical levels in general and a lot of new multifamily product concentrated in relatively few cities. Although overall rent growth remains strong, even as new supply has hit the market, growth in some markets has moderated. Same-store apartment rents for professionally managed apartments tracked by MPF Research jumped at a 4.5 percent annual rate in second-quarter 2016, marking a deceleration of 50 basis points from the prior quarter and a decline of 40 basis points from the prior year.

This market slowdown is being felt more acutely in some regions and metro areas than others, and it also is playing out across asset classes. In particular, Class A apartments have seen a slight slowdown in rent growth and occupancy levels. This slippage is noteworthy because Class A product represents the highest-quality assets — much of it newly developed properties. At the same time, asset prices in that sector continue to rise and cap rates are remarkably still falling. Cap rates hit 5.6 percent as of second-quarter 2016, a decline of 40 basis points year over year, according to Real Capital Analytics.

Whispers of a potential dip in market performance, however, are hardly the only thing driving a pullback in construction lending. A number of events also have contributed to the marked change in the availability and cost of construction debt, as banks have made a concerted effort to reduce construction lending.

First, in December 2015, bank regulators took their first shot at the construction-lending market in a letter expressing concern about the growth and concentration of commercial real estate construction loans on some banks’ balance sheets. Furthermore, the letter said underwriting practices and loan terms at some banks have begun to show signs of weakness. Second, Thomas Curry, head of the Office of the Comptroller of the Currency (OCC), echoed the concern in a statement made to the media after the release of OCC’s Spring 2016 Semiannual Risk Perspective report. “With commercial real estate lending, we are signaling a flashing yellow or a caution light,” he said.

Third, a new regulation requiring banks to hold more capital for construction loans on their balance sheets became effective in 2015. This regulation, called the High Volatility Commercial Real Estate (HVCRE) rule, raised by 50 percent the level of capital banks are required to hold for acquisition and construction loans, driving up costs to borrowers. 

Conservative outlook

As a result of the tightening regulatory conditions, national and regional lenders are exercising a more cautious approach to construction lending. The consequences for borrowers — and the mortgage brokers who work with them — are higher loan rates, lower funding levels, more demanding completion guarantees and, in some instances, an outright turndown of a loan request. For multifamily developers and many mortgage brokers alike, this uncertainty in the borrowing environment can be unsettling.

The delivery of a new apartment community is years in the making, particularly in metro areas with complex, multistage approval processes. Developers must acquire the land, design the product and obtain all necessary permits and approvals before even beginning the site development and facility construction. Increasingly, many developers find their projects set to break ground only to discover the construction loan they were on track to close has suddenly gone sideways.

For now, real estate developers and commercial mortgage brokers working in the multifamily-financing arena can only hope that this is just a temporary hiccup in the market. As markets continue to absorb the demand going forward, and the current book of construction loans reaches maturity, more lending capacity should be created. For now, however, the multifamily market faces some headwinds in accessing construction capital from traditional sources.


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