The speculative nature of construction and development projects makes some commercial real estate lenders wary, especially at a time when a market downturn seems imminent. Recent data shows mixed interest for these types of projects.
Commercial and multifamily construction starts increased in 11 of the top 20 U.S. markets, as measured by dollar volume, during the first six months of 2018, according to Dodge Data & Analytics. The nationwide dollar volume of these construction starts, however, was down 1 percent year over year.
Scotsman Guide spoke with Lisa Pendergast, executive director of the CRE Finance Council, for insight into lender and investor mindsets for ground-up construction deals.
Are lenders being more cautious about construction loans in this portion of the real estate cycle?
I recently did a panel where I asked each of the panelists — and these were all folks who participate in commercial real estate lending and investing — I asked them about where they thought [interest] rates were going be, where they thought the equity market was going to be, whether they thought it was time to really rein in risk, and I have to say they were all of the view that the market will remain relatively benign for commercial real estate.
I’m not putting rose-colored glasses on. I’m just suggesting that there has been a very slow process moving [property values] higher. I think there is a point where valuations are considered by both buyers and sellers to be at levels where caution is advised. So, to the extent that you’re developing new assets in the marketplace, I think there’s a strong sense that it needs to be in the right market, and if you choose the wrong market in today’s extended cycle, there is significant risk.
Which U.S. markets have high demand for construction and associated financing at this time?
The strength lies in those markets where we’re seeing strong tech trends. Clearly, all of Northern California is probably a decent place and yet, in Los Angeles, you’re starting to see an amazing amount of new construction. The question there is, is that a market that can withstand [a downturn]?
I think what’s good is that, if you think about who’s lending in construction, it’s the regulated financial institutions. It’s the banks. Even some life companies are starting to do construction loans. … You also have all these alternative lenders, many of whom joined the space, in part, to take advantage of things like HVCRE (high-volatility commercial real estate) and its negative impact on how much construction lending banks are doing.
Are there property sectors that are seeing more of a construction boom?
Multifamily and industrial are really, really safe plays in many markets, although I think we are reaching a point in certain markets where multifamily would be approached with some caution. For example, here in Manhattan, there has been a lot of multifamily development. It’s not, however, like these [deals] aren’t clearing, if given some short-term incentives to do so — a month’s free rent or whatever it might be.
I think industrial … will continue to be strong. And the issue there is not just new construction. It’s redevelopment on the industrial side. We’re seeing a significant amount of that, and I suspect that will continue. Walmart has just started to focus on industrial [investments] around major cities. At some point, with any sector that’s hot, you’re supposed to keep your antennae up and be somewhat cautious.
Are land-acquisition costs becoming too expensive and holding back some construction projects?
Land-acquisition costs, more than anything else, are a very, very market-specific discussion. … When you talk about acquisition costs, the thing is, you’re buying the underlying dirt, and yet when that asset gets up and running — when you get your [building] permits — what’s the market going to look like then? Are you going to be unveiling this new asset in a market that’s starting to turn? It’s really difficult with talks of tariffs.
A lot of buyers out there are really going to look into where is the upside in this land acquisition? And if you’re a lender, you should be thinking along those same lines as well. … It’s clear that at this point, your construction costs and your values on the finished product really need to be fairly conservative for both lenders as well as borrowers deciding to move forward.