A flaw in many bank’s loan production process is calculating the profitability of a non-owner occupied construction loan that is for investment purposes. These are developer-led projects built for investment and thus subject to construction and market risk. Banks that measure the wrong metrics and don’t have a robust risk management process in place are doomed to create construction loans that detract from shareholder value. The problem is many banks and boards are not aware of this risk. Today, we explain the risk, break down the profitability and highlight how banks can turn construction loan lending to their advantage.
There are three major areas of risk for the developer when constructing investment properties that are all about equal during the construction process. One is the land acquisition and permitting process. Another is the construction risk – can the property get built on time and on budget? The third risk is the financing and lease-up risk – does the property appeal to the market enough to get leased up and release the construction lender? Of the three risks, the acquisition and permitting risk composes roughly 40% of the risk, while construction composes about 25% of the risk and lease-up risk comprises about 35% of the risk. These numbers vary of course based on project, market, technical nature of construction and point in the business cycle, but these are ballpark numbers based on bank loan construction risk over the last 20 years.
So here is the problem, notice that the bank is basically taking 60%, or the majority of the risk. Sure, the developer has equity in the deal, but for many properties the expected loss on that equity is only slightly higher than the expected loss for the bank. Further to this point, while the developer is getting equity-type returns usually in excess of 17%, the bank has debt returns for this equity-type risk for only the coupon on the debt. Even in good markets, when you adjust for the risk, the risk-adjusted return is usually in the 3% range – we run construction loans through a number of industry standard loan pricing models and we are seeing returns ranging from negative 25% (that’s right, negative ROE) to positive 10%. In times of inflated markets, when capitalization rates are low, the risk usually outweighs the return, so the expected return is negative.
Unfortunately, the risk is just part of the problem. A construction loan is one of the most costly loans to underwrite, approve and administer. As such, construction loans have some of the highest acquisition costs with the largest monthly maintenance expense. A construction loan is usually 2 to 3 times more expensive than a commercial office building to administer, often exceeding $2,100 per month. Further, a construction loan isn’t fully utilized from day one, of course, so your average outstanding balance is usually half to 60% (depending on the construction schedule) of the total loan amount.
If all that wasn’t bad enough, a construction loan is short, so banks only have an earning asset for 6 to 24 months. If given the choice, most banks would want a longer term loan.
Most of the problem lies in the fact that a majority of bank pricing models don’t take into account the risk of construction don’t adjust acquisition/administration costs and don’t calculate based on the construction schedule. Worst of all, most models don’t calculate a loan’s value over a set time horizon. As such, while a loan may have a decent return for 12 months, for some period of time during the repayment of the construction loan the funds sit idle earning 0.25%. It would have been better to make one five-year term loan than three construction loans. This is another reason that banks that make decisions driven by net interest margin will be forced into making suboptimal decisions, and banks that make construction loans may think their return is 15%+, but really it’s only a fraction of that (if not negative).
The first solution is to get a real pricing model so bankers can quantify the risk of construction and other loans so that they can make proper capital allocation decisions. The second tactic is to enter into a single close loan so that the construction risk can be paired with the risk and profitability of a longer-term financing. If the construction loan yields an average risk-adjusted return of 3% and the term loan yields a risk-adjusted 18%, most likely the combined risk-adjusted return on both is approximately a respectable 16.6% (because the term loan is earning returns for a longer period than the construction loan). The bank makes a construction loan and then rolls the final draw amount into the permanent or semi-permanent loan. Consider the fact that while almost every lender out there will do the longer-term financing, relatively few lenders will handle the construction loan (unfortunately it is usually the lenders that do not have a robust loan pricing model that takes into account the construction risks). As such, if your bank is willing to make construction loans, then you might as well use it to your advantage.
We created a short video below explaining some other mechanics of working with construction to perm loans. After watching the video we are standing by to answer questions and can help with loan pricing and profitability. Banks are in an ideal spot to provide value during the construction process; smart management will leverage this position to create long-term value for all stakeholders.
Submitted by Chris Nichols on March 02, 2015