Commercial construction spending set new records in 2016. According to ConstructConnect total construction spending increased 4.4% last year (to $1,161T) and is expected to grow 6.3% in 2017. Much of that construction is being financed by the banking industry and a disproportionate share of that lending is originated by community banks. Community banks must be careful to manage construction risk and rigorously consider the risk versus yield in this lending category. We feel that community banks must do three things to improve construction lending results: enhance risk management practices, better measure profitability, and structure their construction portfolio to lower risk and increase revenue.
In 2016 nonresidential construction spending surpassed its pre-recession high. As the graph below shows, nonresidential spending is robust and expected to remain so in 2017. ConstructConnect expects 6.3% annual growth in nonresidential construction in 2017 and over 7% growth in 2018.
The graph below shows construction and development loans as a percentage of all loans for three categories of banks: $100 to $300mm in assets, $300 to $1B in assets, and over $25B in assets. The key takeaway from the numbers is that smaller banks have a much higher percentage of their loan portfolios in construction lending – by a factor of six. Many industry analysts have questioned why smaller banks have a higher propensity for construction lending and if these construction loans have a favorable risk/reward profile.
We feel that there are profitable opportunities for community banks in construction lending, however, banks need to be aware of a few common pitfalls.
Risk Management Practices
Community banks must develop adequate internal risk management procedures to mitigate construction lending risk - this goes beyond credit underwriting. These risk management practices must involve the following:
- Document and cost review. This involves identifying overall scope of work, reviewing documents, plans, budgets and schedules. In today’s market, one area of concern is low budgets and zero contingency funds. This creates heightened credit risk for projects.
- Contractor evaluation. The general contractor creates an important underwriting risk for the bank. Banks must assess the financials of the GC, past experience, personnel, safety results and required licenses. Banks must note that labor shortage may be a big risk in construction in 2017.
- Construction progress monitoring. Proper progress monitoring requires onsite observation, and knowledge and experience for the specific project. Monitoring is conducted to assess quantity and quality of work, conformance with contract and schedule, application of payment, change orders, labor adequacy, available and stored materials, and sufficiency of funding. Banks typically use outsourced expertise for construction progress monitoring.
- Funds control. This involves construction draws, funds administration, and disbursement. This ensures that loan proceeds are used to fund the intended project and ensures that draws conform to budget and schedule.
- Construction completion guaranty or commitment. If the GC fails to complete the project, the bank must have a performance bond or construction completion commitment from another GC. A construction completion commitment can be much cheaper than a performance bond. Smaller performance completion bonds may cost up to 3 or 4% of the project cost. A construction completion commitment may cost 0.5 to 1.0% of the project cost.
Construction Lending Profitability
Standard risk-adjusted return on capital loan pricing models expose some serious issues with pure construction loans. Many pure construction loans are not only unprofitable but in fact have a negative ROE. There are four reasons why constructions loans have a lower ROE than term loans:
- The expected loss on constructions loans is much higher than on many other loan categories. Not only is the probability of default higher on construction loans but the loss given default is also higher. The expected loss on construction loans is on average 11 higher than on CRE term loans.
- The overhead cost for construction loans is high - both acquisition and maintenance costs on construction loans is substantially higher than term loans. Acquisition costs are higher because of the added complexity of underwriting future cash flows and maintenance costs are higher because of the risk management practices listed above.
- The revenue on construction loans is much lower than on standard term loans. The average $1mm, 12-month construction loan has approximately an average life of 10 months and average outstanding of $551k. Thus total revenue is low.
- Cross sell opportunities are limited with pure construction loans. The loans are transactional, borrowers do not have liquidity for deposit products, and because the loans, the customers are not as sticky.
When we compare construction loans and a term loans, using a loan pricing model and keeping all input variables identical (size ($1mm), term (1 year), pricing (Prime flat), credit quality (risk rating 4), we consistently see a 20% to 30% higher ROE on term loans. This is a remarkable difference in return.
How to Lower Risk and Increase Revenue
There are a number of variables that community banks can control to reduce risk and increase profitability for construction loans.
- Loan size makes a big difference on construction loans. Construction loans below $1mm will most likely result in negative ROE. To be profitable, community banks should target construction loans above $5mm. The less specialized a bank is in construction lending the higher the commitment amount required to make these loans profitable.
- Speculative construction loans are a bad credit risk this late in the economic recovery cycle. Upon completion, absorption rates may be much less than expected. Banks should emphasize owner-occupied construction. This category has the added advantage of allowing the bank to add permanent financing and increase cross sells.
- Adding a term take-out to the construction loan adds tremendous value for the bank. The term loan adds balances and duration, thereby increasing revenue. It also eliminates substantial refinance and re-pricing risk. The term loan also increases the stickiness of the relationship and overall profitability for the bank.
There is a remarkable discrepancy in the affinity for construction loans between different banks. On average, smaller banks have a greater percentage of their loans in construction financing. We believe that a large reason for this is because smaller banks have traditionally assessed the risk/return of the construction portfolio through the nominal yield. Taking a quantitative approach to loan pricing, adding the high overhead burden of construction loans and the small amount of actual revenue dollars shows that construction lending can be a profitability drain for banks. However, there are a number of strategies that community banks can take to make their construction loan portfolio more profitable.
Submitted by Chris Nichols on January 18, 2017