NOTE TO READERS: This article was just published in the inaugural edition of the CLRM Journal, a publication dedicated to construction lender risk management and distributed to construction lenders and equity capital providers nationwide. The article is reprinted here with permission from the publisher, Partner Engineering and Science, Inc.
Trends to Watch in the New Year
As the new year gets underway, recession chatter is growing. Notwithstanding the ongoing federal shutdown at press time, virtually every economic barometer is painting a picture of healthy market conditions. In fact, 2018 shaped up to be more robust than many analysts had predicted at this time last year. Below is a list of five trends to watch in the new year.
- The rate of growth in commercial property deals is decelerating.
After two years of consecutive quarterly declines in U.S. commercial property transactions, preliminary data for 2018 signals a return to growth. Fueling the commercial real estate engines were the strongest GDP growth rates the U.S. economy has seen since 2015, coupled with a record-high streak of monthly job creation. Add to that the federal stimulus and tax relief that the new Administration threw on an already-thriving economy. Unknowns surrounding the federal tax plan presented an obstacle to property investment that characterized much of 2017, fostering a “wait and see” attitude on the part of many investors. After the tax plan was finalized late in the year, the market gained momentum in the first and second quarters as deals that had been stalled were put back into motion. The likelihood of further interest rate increases also encouraged developers and investors to secure financing and close deals while borrowing costs were still relatively low. Also worth noting is that the 2018 data indicate that development site sales, which had cooled in 2016 in response to HVCRE regulations, changed course and rose by 9 percent last year.
Yet despite the market’s strong performance in 2018, forecasters at the Urban Land Institute are forecasting declines from the historic highs of 2015 and 2018 to a more sustainable path of transaction activity. The projected slowdown is largely due to the anticipated impact of rising interest rates and the fading stimulus from the federal tax reform package. Smaller deals in smaller metros as investors expand their focus will also likely put downward pressure on the dollar volume of transactions over the near term. And despite the forecast declines, annual volume is still expected to end the next two years well above the 13-year average of $313 billion.
- Headwinds are balancing out tailwinds for the first time in this recovery.
Slowing growth over the near-term is due in part to a trend that characterized 2018. It was a year of transition as the winds in the sails of the market were balanced out by the strength of a number of headwinds (see table). Until 2018, the forces impacting commercial real estate were largely positive, such as the strength of property fundamentals, rising corporate profits, and abundant debt and equity targeting commercial properties. Growing strength in the market, and the ensuing optimism, combined to pull commercial real estate out of the depths of the financial crisis. The longevity of this economic expansion is nothing short of remarkable, having passed the tenth anniversary of the Great Financial Crisis last September.
Now, not only are rising interest rates increasing the cost of borrowing for construction projects and property investment, but property values in many metros across the U.S. are no longer appreciating like they were earlier in the recovery. This means that assets will not necessarily be showing higher yields to accommodate those higher costs. Construction costs are also rising, and labor is in short supply, making it more challenging to pencil in new development and increasing the costs of upgrading older buildings.
While capital is still plentiful, there are more lenders and buyers than there are good deals to finance so competition is fierce. On the political scene, the trade situation is tense and myriad geopolitical concerns risk upsetting confidence in the market. The impact of tariffs thus far remains limited, but that could also change. Last, there is a growing unease about the extended shutdown and the timing of the next cyclical downturn, factors that are making construction lenders more cautious.
- Smaller banks are stealing back market share in construction lending.
Back in the early days of this recovery, banks were essentially the only ones lending, and any developers that did not already have a solid relationship with a bank were likely out of luck. Fast forward to today where the universe of lenders extending capital for construction projects has increased significantly—along with the competition. Banks are no longer so dominant that they’re shouldering all of the risk of funding construction projects. Today risk is distributed among banks, insurance companies, government agencies, private equity firms and alternative lenders.
In terms of share of the overall construction lending pie, the regional/local banks have been on a roll. Back in 2015, regional and community banks accounted for 23% of the total, rising to 33% in the first half of 2018 and 37% for 2017 as a whole.
Some institutions are new to lending on construction projects, while others are looking to grow beyond their traditional, local footprint. Likewise, the share accounted for by nonbank financing companies, mortgage Real Estate Investment Funds (REITs) and institutional debt funds expanded to 21% of construction lending in 2018, up from just 10% in 2015. Over this same time period, large national institutions pulled back on construction lending, accounting for only 22% of the total in 2018 compared to nearly 40% just three years ago.
- Industrial knocks multifamily out of the top seat.
Multifamily had been, until this year, the darling of this recovery. By anyone’s measure, industrial is now in the lead. There is a very deep pool of investors and developers looking to get into industrial, and lenders are favoring loans underwriting industrial projects. Last-mile distribution space is critical to e-commerce, and warehouse space, particularly outside of urban centers, is in short supply. Old, obsolete industrial buildings are getting new life as online retailers strive to be closer to consumers. The good news is that the industrial sector is only just now hitting its stride. In 2018, warehouse construction was up 18 percent, and accelerated growth is expected into mid-2020. In contrast, despite recent growth in multifamily, construction starts will decline in the near term and into mid-2020.
- Caution, cycle-awareness is starting to take root at this late stage of the cycle.
While it’s hard to imagine healthier market conditions, warning bells are sounding that the next cyclical downturn could arrive by 2020. Value-add projects are more attractive as developers and investors search for yield in smaller metros. A sense of urgency is also taking hold as investors and developers look to close deals and secure funding before a market transition or higher interest rates.
These good times won’t last forever so while we are all enjoying a busy start to the new year, it is important to plan for a softening in the market. The strong factors boosting today’s market can mask the risks, and encourage lenders and developers to overreach at this late stage of the cycle. Rigorous due diligence is critical, especially for projects or loans that span a long time-frame.
FOR MORE INFORMATION
The full edition is available here with links to other articles from the CLRM community concerning the construction lending market, construction costs, regulatory updates, risk management and other hot topics, including:
- Beige Book: January 2019
- Dispelling the Black Box Myth
- Global Trade Concerns Driving Cost, Risk Increases
- Construction Costs: Up, Up, & Up
- Federal Legislation Creates New Opportunities
- The Great Recession: Lessons Learned
- Digitization: Improving the Construction Lending Experience
- Appraisal Issues in Construction Lending