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HAMMERED: Wall Street Crisis May Prolong Construction Lending Woes

Some Smaller Banks Face Exposure As Bad Construction and Development Loans Begin to Stack Up. They're Lobbying For a Slice of the Bailout Pie.
October 1, 2008
The Wall Street financial meltdown is turning up the regulatory heat on the state, regional and community banks that fund a large slice of the construction and development lending for projects on Main Street.

To be sure, the problems started well before last month's government takeover of mortgage agencies Fannie Mae/Freddie Mac and bailout of American International Group, Inc. (AIG), the failure of Lehman Bros. and the sell off of Merrill Lynch, Washington Mutual and Wachovia Corp. assets. Construction loans registered their first quarterly decline since 1997 and delinquent loans are rising.

The holders of much of the troubled debt are midsize and smaller banks, which continued making loans after conduit lenders and other commercial mortgage originators that funded development during the private-equity boom virtually disappeared last year as capital markets froze.

However, since the events of last month, community and regional banks now find their cash reserves and loan underwriting practices under greater scrutiny by the Federal Deposit Insurance Corp. (FDIC) and other regulators. More banks are failing and some analysts say the worst is yet to come. See related CoStar Advisor coverage by Senior News Editor Mark Heschmeyer: Tip of the Iceberg: More Banking Problems Could Surface

Not surprisingly, trade groups representing community banks -- defined by regulators as institutions with $1 billion or less in assets -- are among the army of financial industry lobbyists pressing Congress to approve the $700 billion Emergency Economic Stabilization Act of 2008 to help restore liquidity to reeling financial markets. The nation’s 8,000+ community, state and regional banks provide a significant chunk of all business investment in Middle America, including nearly 10% of all construction and development loans by one analyst's estimate.

For more development news, read In The Pipeline, CoStar's weekly column on office, industrial, flex, multifamily, mixed-use, hotel and public works projects.Sign up to be added to our distribution list to receive the column for free by e-mail. This week's column: 'Once-In-A-Century' Project Moves Forward in S.F.

Standard & Poor’s expects that problem construction loan losses will continue to accumulate in coming quarters since most are "bullet loans" -- where the entire principal is due at the end of the term -- that continue to accrue interest until a project is completed. Loan losses will be more acute than in past downturns because of the sharp declines in homes and condominium prices, S&P said in a research note.

"We are watching commercial construction loan portfolios closely for signs of material weakness, notably among construction projects for retail and shopping centers," according to S&P, which said institutions with exposure in California, Nevada, Florida, Arizona, Georgia, and Michigan are seeing the most adverse credit impact.

Zero Lending Activity

Almost no construction financing is available in the marketplace right now, mostly due to the problems of the regional and community banks, Charles Halladay, associate director with the Irvine, CA office of Holliday Fenoglio Fowler, LP (HFF), told CoStar Advisor.

"Only very low-leverage construction loans are going to get done in today’s market -- banks might look at a very low-risk asset class like apartments," Halladay said. "Where construction lenders used to be able to underwrite to rent growth, expense growth and lower interest rates and debt coverage on the back end, they’ve recently had to increase a lot of those assumptions because of the tightened oversight. Those few still doing loans are well capitalized with clean balance sheets."

With community bank liquidity, deposits, capital ratios and other operations under strict watch in recent weeks, "the middle-market borrowers, for example an Orange County developer with three to five projects who looks to his three or four banking relationships to get financing -- those people are having a lot of trouble getting funded right now," Halladay said.

Problem Loans Mount

In the second quarter, 6.1% of the $627.2 billion in construction and development loans held by rated banks were "noncurrent," meaning 30 to 89 days past due, according to the FDIC’s second-quarter Quarterly Banking Profile. Noncurrent real estate construction and land development loans rose by $8.2 billion, or 27.2%, between the first and second quarters.

According to Oakland, CA-based Foresight Analytics, construction and land loans more than 30 days past due rose from 7.2% of loan volume in the first three months to 8.1% during the second quarter, compared with just 3.2% in the third quarter of 2007. Delinquency rates for single-family and condos rose to 12.5% and 16.5%, respectively, according to Foresight.

Charge-offs of construction and development loans rose by $3.2 billion, some 1,226%, in the quarter ending June 30, according to the FDIC. Meanwhile, construction loan volume declined for the first time since first-quarter 1997, falling by $5.4 billion, or 0.9%.

The problems remain weighted toward loans to residential builders -- although delinquency rates for apartment and office, industrial and construction are rising. Significantly, commercial delinquencies are now higher than their peak in third-quarter 2001 during the last real estate downturn.

Overall commercial construction loans outstanding were up slightly from first-quarter 2008, but well off the rapid pace of 2006 and 2007. Analysts believe the loan-funding pace will slacken further and delinquency rates continue to rise as property prices continue to soften.

One direct commercial lender noted that he hasn't seen an extraordinary rise in commercial defaults in the market unless a project has a large residential component.

"I have seen a couple of small shopping centers and some office and medical condo projects going south, but they seemed like highly leveraged deals, or not well-located properties," said Bill Owens, chairman/CEO of Walnut Creek, CA-based Owens Financial Group.

Owens said his firm is conservative, focusing on lending to smaller, well-capitalized projects of less than $20 million.

"We are requiring significant cash equity, at least 25% of costs. We are not making acquisition or construction loans unless properties are 75% pre-leased," Owens said. "We’re making some small apartment construction loans for well-located properties.

"Borrowers today are very realistic about the difficulties in the financial markets. If anyone can wait to do a deal, they are waiting."

James Gunning, executive vice president with CB Richard Ellis Capital Markets in Saddle Brook, NJ, said most community and regional banks in his market remain active. However, borrowers "won’t get the crazy money" they did before credit markets seized last year, when 80% to 100% leverage was commonplace.

"It was very cheap equity then. No matter what the value, you now have to have a substantial amount of hard money in the deal," Gunning said. In one stabilized office transaction Gunning is working on, for example, the prospective buyer had to put up more than 41% of the $34 million purchase price. The investor recruited an equity partner.

Gunning said pre-leased commercial, industrial and retail developments will find lenders, but most spec commercial and condominium developments probably won't. Apartment development loans may get funded as long as pro forma rents are reasonable.

He predicts that within two or three years after Congress passes the recovery package, the commercial real estate market will only be "somewhere between where we are now and where we were in 2006."

"It’s going to be a long time before people get as aggressive as they were then."

Except for select agency programs such as Fannie Mae/Freddie Mac/FHA/HUD, "most funding sources are waiting for more clear market signals for the remainder of the year," noted Jeff Davis, advisory board member of the Real Estate Capital Institute. "Active lenders seem to have met their allocation goals as funds continue drying up within the securitized lending sector."

Will Bad Building Loans Be Rescued?

Among the many things that remain unclear about the proposed $700 billion federal rescue package is whether it will buy up bad construction loans from regional and community banks, the same is it plans to do for troubled mortgages.

The Independent Community Bankers of America (ICBA) has asked Congress to include a broad list of eligible institutions and assets types in the Act, and allow community banks that purchased now-impaired preferred shares of Fannie Mae and Freddie Mac to deduct those losses from income. A measure to raise the amount of FDIC deposit insurance carried by banks to help level the playing field for smaller banks was part of the bill adopted by the Senate on Wednesday night.

"The current liquidity and credit crisis has constricted the flow of funds to Main Street America and has driven up the funding costs of community banks, thus further limiting the availability of credit in local markets," ICBA Chairman Cynthia Blankenship and President/CEO Camden R. Fine said in a letter fired off to lawmakers last week.

Contractors Feel the Pain

Busted development deals are hurting the bottom lines of general contractors and related construction fields.

Jeff Lindbloom, vice president of Comprehensive Construction Services, Inc. based in Naperville, Ill., said nearly all of his industry colleagues have seen projects go south in recent months. In some cases, banks have forced borrowers to re-qualify under tighter underwriting after a project has already broken ground.

"A lot of us have money tied up in sour projects. Some projects have stopped, others have sold, others have been liened against or gone into foreclosure," Lindbloom said. "Some of the banks found that developers are spread too thin and asked them to come up with more liquidity or assets to tie up, or they won’t fund the project."

Even though a bailout package might help his industry, Lindbloom has very mixed feelings about such a massive government intervention into the private sector.

"I’m personally against the bailout. It’s not a good deal for us as general consumers, knowing banks are being forgiven for a lot of bad loans. The banking bailout might help get those projects started. I don’t know if it would be instantaneous, but it would get the wheels moving again, it might clean the pockets of the banks of the bad loans."

One bright spot on the funding horizon is mezzanine and opportunity debt funds, which remain very liquid in the market for strong borrowers with well-located projects, HFF's Halladay observed. "You will have numerous bids on a deal if you have mezz in it. The trouble isn’t getting from 60% to 80% on the capital stack, it’s getting from zero to 60%, getting that first trust deed."

In one recent example, Cassidy & Pinkard Colliers arranged a $212 million bridge loan for The Portals III, a 500,000-square-foot office building at 1201 Maryland Avenue, SW, in Washington, DC. The two-tier financing included a senior loan with an unnamed West Coast commercial bank and a mezzanine loan provided by a national pension fund advisor, arranged on behalf of Republic Properties Corp. The Portals III, delivered in 2006, is 45% leased and is the third office building in the $1 billion Portals mixed-use development in the nation’s capital.

With the difficulty in finding adequate senior debt, "mezzanine debt has become a critical component of most recapitalization efforts," said David Webb, the Cassidy & Pinkard Colliers senior managing director who structured the package with senior VP John Campanella and other colleagues.

"We explored two, three and even four tiered structures, but fortunately were able to achieve maximum efficiencies with only two lenders," Webb said. "Republic quickly recognized today’s realities and moved ahead" on the deal.

For more news on development, read In The Pipeline, CoStar's weekly column on office, industrial, flex, multifamily, mixed-use, hotel and public works projects.Sign up to be added to our distribution list to receive the column for free by e-mail. Read this week's column.

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