RCA Insights

Changing Gatekeepers of Construction Financing

By on May 29th, 2018

The Dodd-Frank reform passed last week includes provisions which will clarify certain U.S. rules on bank lending for real estate construction. Those rules were implemented in 2015 and the competitive landscape for construction financing shifted as a result. National banks lost market share as debt funds grew in importance. Will national banks gain that share back?

The language around the original High Volatility Commercial Real Estate (HVCRE) regulations implemented in 2015 was a bit fuzzy. The rules were open to interpretation and national banks – those subject to the most stringent capital regulations – pulled back on their construction finance activity.

Back in 2015 national banks were the primary gatekeepers of construction financing. These banks were responsible for 36% of all construction loans originated. Their share of the market has fallen to only 27% of all construction financing in Q1’18.

1805 HVCRE main

As the national banks pulled back on construction financing, the financial companies stepped up their lending. This category of lenders, which includes the debt funds, has seen market share grow to 16% by Q1’18. These lenders gained market share as they went into the loans on high-price office and residential condominium deals in the larger coastal markets, where the HVCRE regulations had introduced caution on the part of national banks.

The legislation last week cleared up two poorly crafted components of the original HVCRE regulations.

First, developers are required to put some of their own equity into construction deals to qualify for bank construction loans. To the extent they were treating the land as part of that equity, the original regulations only allowed these developers to count the original book value of the land and not the current market value. The reform allows developers to use the current appraised value of the land.

Second, the original HVCRE regulations limited financing options for value-add properties and rolled these projects under the same stringent capital requirements. The reform removes these projects from the HVCRE status.

Will these changes bring the national banks back to the forefront and displace the debt funds? The fundamental capital requirements for HVCRE loans have not changed because of the legislative reform. National banks will still face higher reserve requirements for pure construction loans.

Value-add deals, though, do not face that same constraint and national banks may well step up activity for deals of that structure. For pure construction loans, the changes to land valuation may change the competitive situation.

Debt funds have stepped up to provide financing in precisely the markets and deal sizes where the national banks pulled back. Large loans in the expensive coastal markets simply no longer worked as easily for these lenders as in the past. Now though, developers in these markets who have an equity stake in banked land may be able to work more easily with the national banks than in the past couple of years.

Jim Costello

Jim Costello

Senior Vice President

Jim Costello has worked in the CRE space on issues of urban economics since 1990, including a 20-year stint at Torto Wheaton Research. Jim expanded the reach of the Torto Wheaton Research team developing forecasts of global market fundamentals. He also developed approaches to pair the forecast results with frameworks to answer investor questions on asset values and relative investment opportunities.

In the aftermath of the Global Financial Crisis, Jim provided advice to the Treasury Department and helped educate these professionals on commercial real estate performance. Jim is a member of the Commercial Board of Governors of the Mortgage Bankers Administration, where he helps policy makers understand the commercial real estate industry.

Jim is expanding the capabilities of the Real Capital Analytics team on issues of real estate market dynamics. Jim has a master’s degree in economics and is a member of the Counselors of Real Estate.