A recent report from the American Institute of Architects shows that nonresidential construction spending is expected to slow to a growth rate of 5.8% in 2023 (down from 10% in 2022) and then fall to a mere 1% growth rate in 2024. Recent years brought new stresses on the industry – COVID-19 shutdowns, supply chain woes, labor shortages and bank failures have slowed projects or put them entirely on hold.
Associated Builders and Contractors predicts that the construction industry will need to attract more than 500,000 extra workers in 2023 – on top of the normal pace of hiring – to meet labor demand. Real estate valuations are softening and have negatively adjusted in many markets as well. In Los Angeles, for instance, office building valuations declined by 40% in the first two months of the year, according to data from Yardi Matrix.
At the same time, the cost of capital has risen considerably. Starting in March 2022, the Federal Reserve began hiking interest rates to quell inflation, which hit the highest level seen in four decades in late 2022. While the Fed’s efforts appear to have slowed inflation, a number of macroeconomic factors suggest a rough patch still lies ahead for the economy. This includes volatility in the bond markets and turbulence in the banking sector. Silicon Valley Bank’s failure in March was the largest since the Great Recession. Signature Bank shuttered days later, and Credit Suisse was swallowed up by a rival in the wake of its struggles. In turn, economists are seeing a pullback in bank lending — a trend that will affect commercial construction in the months ahead.
The Current Lending Landscape
Lenders, builders and developers are grappling with tightening credit conditions. Banks are monitoring portfolios and focusing on specific loan types and/or submarkets for signs of distress. In construction portfolios, if there is a sudden slowdown in draw requests, or construction timelines aren’t met, lenders will have to examine underlying conditions affecting loan performance. Any unmet covenants or non-monetary defaults will drive lenders to adjust their risk posture, stiffen adherence to agreements and review individual loan commitments more rigorously.
Changing dynamics have also impacted the number and size of loans:
- Residential loan volumes still stand lower than peak levels before the housing crisis. According to ATTOM Data Solutions, the number of residential mortgages issued in the fourth quarter of 2022, for example, dropped 24.5% from the third quarter, putting it at the lowest level since early 2014. It was the seventh quarterly decline in a row.
- Builder confidence declined for 10 straight months last year according to the National Association of Home Builders, with construction spending dipping across most sectors, except for manufacturing and educational projects. However, it has since rebounded moderately.
- Higher material costs and interest rates make loans more expensive than they have been in the recent past, and builders are experiencing slower absorption levels.
Many banks are protecting themselves from risk and potential loss by increasing loan loss provisions, raising balances to cover non-performing loans and foreclosure losses. S&P Global Market Intelligence reports that of the 19 banks with over $50 billion in total assets that announced fourth-quarter earnings in late January, 14 of them saw an increase in provisions compared to the previous quarter. Modeling for future expected credit losses will be a key focus of bank examiners in this year’s full-scope or targeted regulatory audits. In short, banks are projecting a rise in future losses, potentially impacting earnings and capital ratios.
While the construction industry is experiencing more scrutiny from banks during the lending process, some segments are seeing trends toward growth. These include digital infrastructure, cellular systems and data centers, healthcare, and low- to moderate-income multifamily housing. Stakeholders in these industries may see favorable responses from banks for loan requests if these trends continue.
Differences in Lending Practices
Banks first began tightening their lending practices in the wake of the Great Recession because of the Dodd-Frank Act and other legislation. This created an opportunity for non-bank lenders, who typically offer greater flexibility with loan terms and potentially faster approvals. (According to the U.S. Chamber of Commerce, a non-bank lender is “a financial institution that lends money but doesn’t operate with a full banking license. It does not offer deposit, checking or savings services.”) However, for borrowers, the flexibility of alternative lenders comes with higher rates and greater demands for performance compared to traditional banks, since their portfolios are often financed by secondary investors who maintain strict standards.
Non-bank lenders also tend to be more aggressive than traditional banks when it comes to recovering investments in non-performing loans. They’re more likely to pursue remedies immediately for non-performance, including foreclosure or note sales. This can negatively affect the value of other comparable properties in the same market.
When navigating uncertain macroeconomic conditions, IT and business intelligence become increasingly important. Digitally collected asset management data solutions can provide additional levels of visibility into construction loans and collateral progress, often acting as the first line of defense in identifying predictive risk characteristics. These solutions track key metrics of loan performance and enable informed asset management decision making. Non-banks often have more flexibility to digitize paper-heavy, manual workflows and streamline lending processes, whereas traditional banks tend to rely on outdated legacy systems.
The Importance of Transparency
Once again, a primary concern for builders in this market revolves around materials shortages and supply chain issues. This has been evident for a while. By the fourth quarter of 2021, for example, the U.S. Chamber of Commerce’s Commercial Construction Index reported that 46% of contractors estimated they would have to pay more for materials than in the previous quarter, and virtually all of them indicated that those costs would have a significant impact on their businesses. Since that time, prices for materials such as copper and lumber have fallen due to reduced supply chain backlogs and lower tariffs, but high interest rates and inflation remain an obstacle. Increases in the cost of materials and loan financing have a ripple effect, leading to delays and cost overruns.
Fluctuating material costs and backlog issues make project visibility more important than ever. (In construction, project visibility refers to the ability to monitor and track the progress of a project in real-time, as well as to identify any potential issues or delays before they become significant problems.) Greater visibility means greater risk mitigation, giving lenders an advantage in tight economic times. Surveillance monitoring and an understanding of what’s happening with projects on a granular level – from drawdown delays to material disruptions – offer another layer of protection for loan performance.
The bottom line is that uncertainty is perhaps the only sure thing in the year ahead. Predicting where events are going and taking swift management action based on data will protect lenders and limit risky exposure in today’s rapidly changing market.