Construction and Land Development loans (C&D loans) drove a substantial portion of the loan growth at community banks between 2000 and 2007, especially for banks under $2B in assets. While C&D loan volumes bolstered total loan growth, these same loans resulted in substantial detraction from risk-adjusted return on equity (ROE). In fact, C&D loans were one of the major causes of bank failures from 2009 to 2011. Compared to their peak in 2007, current C&D loan portfolios are relatively small. That said, for many community banks, C&D loans still demonstrate a negative ROE on a risk-adjusted and fully cost allocated basis. However, this does not need to be the case. For the smart bank, there are ways to manage a profitable C&D loan portfolio so that the portfolio delivers a positive risk-adjusted ROE through each business cycle.
The table below shows C&D loans as a percentage of total loans from 1995 to March 2015 for banks under $2B in assets and for banks over $50B in assets. A few important observations: 1) smaller banks demonstrate a much larger C&D loan portfolio as a percentage of total loans through the entire 20-year period; 2) Both larger and smaller banks have decreased their C&D loan portfolio from their peaks in 2007, but larger banks have returned their C&D loans to historical lows, while smaller banks still show elevated C&D loan portfolios; 3) The data understates the contrast between the smaller and larger banks because many smaller banks that expanded their C&D loan portfolios have failed and their data is not represented in the blue line below.
From 2003 to 2007, C&D loans were expanding at 19.4% year-over-year for banks under $2B in assets. For these same banks, C&D loans grew to 11.2% of the entire loan portfolio in 2007. While C&D loan volumes were expanding, risk-adjusted ROE was dropping. The following are the reasons that C&D loans generally have negative risk-adjusted ROE:
- The credit risk associated with these loans is very high: The probability of default is not only high; it is very correlated to systemic risk. While defaults can occur two or three years after a recession for consumer loans, by comparison a construction loan is almost instantaneous. During early 2008, probabilities of default for construction gapped wide within about 45 days from the start of the recession. Further exacerbating this problem is that default rates and severity of losses for C&D loans shows a high positive correlation. Put another way, as C&D loan default rates increase, the losses associated with the defaults climb exponentially. In the last credit cycle, defaults on C&D loans peaked at 16.2% and losses on some entire portfolios ran at more than 60% of exposure.
- Revenue from C&D loans is relatively low. For the average $1mm, 1-year construction loan, community banks generate just under $15k in gross interest margin based on prevailing margin. The reason for the low revenue is the short-term nature of the facility and low average outstanding relative to the commitment amount. Not only is the loan short, but the lifetime value of construction customers are also the shortest of any major customer class.
- The overhead costs for C&D loans are among the highest of any major loan category due to the monthly loan maintenance, risk management, operations plus the cost for initial underwriting. In addition, acquisition costs (not including underwriting) usually exceed $9k for sales and marketing expense.
- C&D loan customers typically do not provide the bank with much cross-sell opportunities. Most developers lack liquidity and leave relatively low balance deposits with little treasury services to generate fees.
We have modeled a typical construction loan on our Smart Loan Express pricing model and, even with a 50 basis point upfront fee and Prime + 90 basis points the ROE is a big zero (below).
Rather than book the initial C&D loan and allow another lender to then bid on the permanent takeout facility, community banks should commit to a single closing with a construction facility and a takeout facility. One reason that construction lending has been such a draw for community banks is the lack of competition from the national and larger regional banks especially on credits below $10mm. Because the term loans are much more profitable than the C&D loans on a risk-adjusted basis, the national and regional banks will avoid the construction loan only to bid aggressively on the term takeout facility. The opportunity for community banks is to eliminate the competition for the term facility by making the construction loan contingent on a single closing for both (construction and perm). Community banks can generally garner substantial margin on the takeout loan if the combined facilities are properly structured at inception of the construction period. We have witnessed banks able to price 50 or 75 basis points above market margins on the take-out financing by making the term loan a requirement for the construction commitment. This would drive total risk-adjusted ROE from negative numbers to over 15%.
Below, we take the same example as above, except add a ten-year loan after the construction period, give the borrower a fixed rate, use our ARC Program to hedge it back to floating and turn it into a risk-adjusted 17% ROE (below). Mind you that this is still at a very competitive market rate at 1-month Libor + 2.40%. If you can pick up and additional 50 basis points for providing both the construction and the permanent loan, the risk-adjusted ROE comes out to an impressive 23%.
Commercial real estate prices are now 27% above their peak that was set in November of 2007. This increase in property values is driving construction lending. As we have proven above, the last thing you want to do is to just make the construction loan and come out negative. Your bank either wants to just make the semi-permanent or permanent loan at market competitive rates or better, make both the construction and the permanent loan and increase pricing to more than offset your risk. This strategy holds especially true for smaller loans (under $10mm in size) where national and regional banks are willing to commit to term loan structures but loathe to participate on the construction portion. This is another example of how community banks have an opportunity to exploit a dislocation in the market and earn an above-average rate of return.
Submitted by Chris Nichols on July 08, 2015