Boston CLRM: Construction Lending Amid Market Shift

At the end of September, I had the pleasure of speaking at the Construction Lenders Risk Management forum in downtown Boston. Hosted by Partner Engineering’s Bill Tryon and Elizabeth Krol, the event drew developers, construction lenders, real estate attorneys from the area’s top firms. It was a lively crowd, eager to share what business is like in one of the country’s hottest real estate markets. Below are the five talking points I shared–many of which apply to the broader market as we head into the final quarter.

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  • “Goldilocks era” — not too hot, not too cold. There’s a tug of war going on with optimism on one side and caution on the other. If you only read the Wall Street Journal headlines about double-digit declines in commercial real estate transactions every month, you might think the sky is falling. It’s not. Deal volume is…but there’s more to the story. 2015 was the best year this recovery has seen. It’s just been extremely difficult for the market to maintain that pace of velocity. Other big influencers of the market this year have to do with key shifts in the market: rising interest rates (borrowed capital is more expensive), flattening property prices (that $10M building might only be worth $9M a few years from  now), shifts to smaller deals in smaller metros (lower overall deal volume in $ terms), and growing fears that the next cyclical downturn is nearly upon us (it’s coming eventually). In the context of these trends, 2017 numbers aren’t all that surprising. Buyers aren’t as willing to pay last year’s prices, and sellers don’t want to discount yet because the market is still decent—or they may not be as motivated to sell if they don’t have to. These factors are all largely are to blame for commercial property investment volume being off this year.
  • Lenders are “risk-off.” The market shift means deals this year aren’t the sure thing they might have been a few years ago. That adds up to more caution, more questions, more assurances, more negotiating, more investigations, quantitative analysis—good news for anyone in the risk management field. The OCC just called out almost 400 institutions in its latest Risk Perspective report that have at least 25% of capital tied to commercial real estate loans and a 3-year growth rate of 50% or more. Construction lending fell last year under the HVCRE requirements, which mandate 50% in cash reserves on the part of the lending. So it shouldn’t surprise anyone that underwriting on construction projects has been tighter, and projects with skinny margins face an uphill battle getting financing. As one lender with a large national institution told me: “We currently have about 18-20% in construction lending, mostly multifamily, and are looking to keep it to about the same percentage. We’re being really careful about construction lending right now and are looking for very predictable income. Nothing that can get in the way of that.”
  • Everyone loves Boston! Boston’s market benefits in a huge way from strong demographics and a robust business climate. And they’re pretty jazzed up right now about the excitement surrounding the Suffolk Downs site in Revere as a candidate for the next Amazon headquarters. EDR’s ScoreKeeper model, a key barometer of deal-making activity across the U.S., ranks Boston as the fourth largest market for Phase I environmental site assessments. As of the third quarter, there were 5,500 Phase I ESAs conducted in the greater Boston metro, with no signs of slowing down.

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“In a knowledge-based economy, brain hub markets like Boston win.” ~ Area investor

 

  • Value-add is in vogue

In their quest for a solid ROI, investors are turning to value-add opportunities in smaller, less competitive markets. “What can I buy at a good price in a growing metro? And then improve on? And then sell down the road for a profit?”

There is a shortage of good deals, so investors are looking to opportunities to repurpose properties. This could mean energy-efficiency improvements, brownfields redevelopment or a full-blown change in use. An old mall becomes a medical center or a sparkling new mixed-use development or senior housing center. An old manufacturing facility gets turned into an apartment building in an urban center. An old horse race track by the airport gets the attention of the largest e-commerce player in the country. All of this adds up to more development and construction projects in metros where the numbers work.

  • Nothing in the forecast is telling us to panic.

Barometers are pointing to another 18-24 months of moderate economic growth. The Urban Land Institute expects commercial real estate transactions to fall by 8 percent this year, stay flat in 2018 and decline by a more gradual 4 percent in 2019. Buyers and sellers are adjusting their expectations in light of market shits and yes, there’s some softening, some pullback as a result. Should we worry? Not yet.

There is a lot of capital that wants to deploy in U.S. property markets. And although multifamily housing starts are in a recession, most construction sectors especially warehouse and office are expected to provide growth opportunities into at least the second half of 2018. On the risk front, expect a period of greater selectivity and elevated risk management by lenders—and a lot of competition. Today you can make a bad deal as price increases are no longer guaranteed. Expect more demands for efficiency too as buyers scramble to get the good deals before the market goes south. What we can all be most grateful for are solid conditions in most asset classes and largely positive confidence in the market. That matters more than anything.

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Thanks to Elizabeth Krol and Bill Tryon for including me in the Boston CLRM lineup. I thoroughly enjoyed the audience and other speakers!