The commercial real estate market is changing, as demand for new construction grows along with rising costs and interest rates. How do community banks fit in the bigger CRE picture? Lenders share some of their insights into operating in this fluid market.
By Beth Mattson-Teig
Developers are keeping their foot on the gas for new commercial real estate and multifamily building projects, and community banks are often the go-to source for construction loans. Yet lenders also face stiff competition for loans and growing challenges in underwriting deals amid rising costs and higher interest rates.
Year-over-year rise in number of multifamily building permits issued, March 2021 to March 2022
“There clearly are headwinds with supply chain issues, cost increases, rising interest rates and the desire for seemingly every bank to want to grow, creating a very competitive lending environment,” says Brian Schott, division executive and commercial real estate team leader at $13 billion-asset Sandy Spring Bank in Olney, Md. Year-to-date through May 2022, demand for construction loans was relatively consistent as compared with 2021, he notes, with a good pipeline of opportunities ahead, even if those new loans are often being pursued by multiple lending institutions.
Growth in CRE activity—and costs
Industry research is pointing towards modest growth in construction activity in 2022. Dodge Construction Network is forecasting a 6% increase in the value of construction starts this year.
Two of the most active property sectors for community bank lenders have been apartments and industrial. Demand for space has been incredibly strong in those sectors and both have a healthy queue of projects. According to the National Association of Home Builders (NAHB), the total number of multifamily permits issued over the 12-month period through March 2022 climbed to 153,720—17.1% higher than the same period last year. In the industrial sector, developers completed 90 million square feet of new inventory in first quarter, with an additional 531 million square feet of space under construction, according to commercial real estate services company JLL.
“I think our volume will continue to be up in 2022. I just wonder how much higher [construction] costs can go,” says Jennifer Cooper, senior vice president and commercial real estate lending manager at $6 billion-asset Bankers Trust in Des Moines, Iowa, which also has branches in Ames, Iowa, Cedar Rapids, Iowa, Sioux Falls, S.D. and Phoenix, Ariz, with a lending production office in Omaha, Neb. As an example, the average total cost to build an industrial warehouse jumped 21% last year, according to JLL. Eventually, higher costs need to be passed down the food chain from tenants to consumers, Cooper says.
Rising construction costs, inflation and the rising interest environment are all contributing to a fluid market and challenges in underwriting loans. “It is difficult to determine what an appropriate interest rate is when underwriting the takeout financing,” says Schott. It is impossible to predict where rates are going tomorrow, let alone predicting what they will be in 18, 24 or 36 months.”
“Spec can be a bit of a dirty word in lending, but we’re doing those projects with developers who have pretty substantial balance sheets and the ability to cover costs if there are increases.”
—Jennifer Cooper, Bankers Trust
Lenders at Sandy Spring Bank have also started to see borrowers request to increase loans to cover higher costs. In those scenarios, Schott adds, it is important to be sure those loans still underwrite with an increased loan amount and to structure the increase such that the borrower is sharing in the cost increases by way of injecting additional equity.
Bankers Trust originated about $500 million in construction loans in 2021. About 30% of those loans were for industrial, including both spec and build-to-suit properties.
“Spec can be a bit of a dirty word in lending, but we’re doing those projects with developers who have pretty substantial balance sheets and the ability to cover costs if there are increases,” says Cooper. “So, our underwriting is back to the basics of whether the client has their costs locked down, and if they don’t, what level of cost they can absorb without damaging their financial position.”
Bankers Trust has also developed an internal underwriting model with a sensitivity component that models different scenarios, such as how low rents can go or how high interest rates can go before the loan breaks even. “At the end of the day, it’s all about relationships and that borrower’s financial strength. So, we really spend a lot of time looking at the borrower’s net worth and liquidity and experience,” says Cooper.
Finding a competitive edge
Although banks have traditionally dominated the construction lending space, community banks do face stiff competition. There is a lot of liquidity in the market, and banks are competing with life insurance companies, debt funds, REITs and other banks.
“It is a competitive lending market, but there is still definitely space for community banks. They fill a need. They have a lot of dry powder with cash in deposits, and they need yield,” says Patrick Minea, executive vice president and executive managing director at Northmarq, a national capital markets and mortgage brokerage firm.
One area where community banks have an advantage is in making loans in smaller tertiary markets, where they can leverage their local market knowledge, notes Minea. Community banks can also work together on participation loans, which helps to preserve capital, diversify their risk and still service existing clients.
“Lending has become a little bit commoditized, so you are trying to figure out how you can be a good partner for the customer and meet their business needs,” says Damon Peters, senior vice president and commercial real estate manager for the Minneapolis-St. Paul region at $10 billion-asset Bell Bank in Fargo, N.D. “What lever as part of that financing structure do they need us to move to help them be successful?” That’s where community banks need to be flexible and nimble to help clients find solutions, he adds. For some borrowers, they might need a low rate, higher leverage or non-recourse. In other cases, a client may be willing to pay a slightly higher rate to get more flexibility around the covenants structure.
“Where community banks do a really good job is in flexibility and nimbleness and creativity,” says Peters. They don’t have the same underwriting box that big banks have with specific metrics, he adds, and they can also be more flexible in how they structure a deal. For example, some community banks are willing to offer a five- or seven-year fixed-rate construction loan at closing, whereas a middle-market bank will usually only agree to a floating rate loan, often a three-year deal with an extension option.
Customer service is another cornerstone for growing construction lending. “Service is simple to say, but not so simple to put in place,” says Schott. “Each step along the way is very important to be responsive and attentive in every way.”
He adds that once the loan is closed, the construction loan administration process is extremely important, especially in this environment with supply chain issues. “It is often this level of experience that not only gets us to settlement, but also encourages our clients to recommend us to other real estate developers,” he adds.
Industrial space in high demand
Despite rising costs, demand for industrial space has exploded along with growth in e-commerce. Rents for industrial projects in the Midwest that were typically between $3.50 and $4.50 per square foot have jumped to well above $7, notes Jennifer Cooper, senior vice president and commercial real estate lending manager at Bankers Trust in Des Moines, Iowa. In other high-growth markets such as Arizona, rents have surged past $10 per square foot. Strong occupancies and rent growth are fueling building activity, particularly for warehouse, logistics and “last mile” delivery locations.
On the multifamily side, some apartment developers are struggling to make the numbers pencil out due to higher construction and land costs. “The Midwest doesn’t have the massive income gains that the coasts are seeing,” Cooper says. “So, the issue that we’re all running into is that with costs the way they are, the ability for people to be able to pay higher rents to support construction costs is a huge challenge.” For example, some apartment developers in rural Iowa were projecting construction costs as high as $285 per square foot, which contributes to a financing gap. Most of the apartment construction loans Bankers Trust originated last year were out of its Phoenix office for projects in Arizona and southern California.
Beth Mattson-Teig is a writer in Minnesota.