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More CRE Banks Test the Waters of Construction Lending, but Risks Abound - Report

June 11, 2018, 07:18 AM
Filed Under: Construction

A reliance on spread revenue and narrow business models can present a credit challenge for banks concentrated in commercial real estate (CRE) lending relative to more diversified regional banking peers, Fitch Ratings says. Interest rate risk from liability-sensitive profiles and a reliance on wholesale funding can also limit financial flexibility, especially in a rising rate environment. As such, Fitch believes that relatively stable deposit funding will be a primary differentiator and competitive advantage among CRE-concentrated banks.

For the U.S. banking industry, construction loans had a peak credit loss rate of 8.0% during the financial crisis, compared to a peak blended loss rate for all loan types of 3.0%. Banks with CRE loan concentrations generally have lower credit losses than industry averages, and most have avoided construction lending. That said, a small group of concentrated construction lenders have emerged in recent years, contrary to the broader industry trend of pullback in construction lending. These lenders have yet to be tested through a credit cycle.

Niche multifamily lenders in stable markets like New York and California may benefit from rent regulations that drive low vacancy rates and predictable cash flows, which can help offset the concentration risk in these loan portfolios. Moreover, these lenders typically have minimal exposure to the relatively volatile high end of the multifamily market. However, many of these lenders also have liability-sensitive balance sheets, unlike other banks that can position balance sheets to take advantage of rising rate environments and therefore could be hurt by rising interest rates.

Over the past five years, some CRE-concentrated banks have increased relative exposure to construction loans, which has been contracting for the industry in general. Loans financing the acquisition, development or construction (ADC) of real estate have repayments dependent on future sales or refinancing. Construction lending drove bank charge-offs during the financial crisis, and the industry has reduced relative exposure to construction lending since then. However, Fitch notes that some banks have chosen to either grow or maintain their ADC portfolios at over 100% of risk-based capital.

The recent Economic Growth, Regulatory Relief, and Consumer Protection Act (S.2115), which passed the Senate in March, includes language easing the definition of high volatility commercial real estate (HVCRE), which currently attracts a 150% risk weighting. HVCRE typically would capture certain ADC loans. The Senate bill seeks to narrow and more clearly define the scope and capital requirements for HVCRE lending, which could make it more attractive to banks. HVCRE loans typically fund relatively leveraged commercial real estate construction projects that are intended to be tenanted rather than owner occupied. A notable change to the rule is the allowance of the appraised value of land, instead of historical cost, to receive credit toward the 15% capital contribution required for a loan to be exempt from HCVRE designation.

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