Credit Standards on AD&C Construction Lending: A Tale of Two Sectors

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According to National Association of Home Builders’ Survey on Acquisition, Development & Construction Financing, residential real estate builders and developers reported that credit conditions for acquisition, development, and single-family construction loans were easier in the second quarter of 2016 than in the first quarter of 2016. Hence the National Association of Home Builders net tightening index dropped from its level in the first quarter.

Following 5 consecutive quarterly declines in the pace of net easing, more respondents on net, 25.0%, reported that credit standards on acquisition, development, and single-family construction financing had eased in the second quarter of 2016 from the first quarter. In the first quarter of 2016, 13.3% of survey respondents on net indicated that overall lending standards on acquisition, development, and single-family construction loan availability had eased. However, the net share of respondents reporting that lending conditions have eased in the second quarter of 2016 is lower than the net share reporting easier standards at the same time in 2015, 30.7%. The index is constructed so that negative numbers indicate credit easing, and positive numbers mean that credit is tightening.

The Federal Reserve Board also tracks lending standards on acquisition, development, and single-family construction lending. In contrast to the National Association of Home Builders results, the Federal Reserve Board’s Senior Loan Officer Opinion Survey indicates that lending standards continue to tighten. As illustrated by Figure 1 above, lending conditions reported by the Federal Reserve Board began to tighten on net in the second quarter of 2015 and has remained tight in successive quarters.

Given the recent divergence of the two indexes it is important to understand the similarities and differences between them. Although both the National Association of Home Builders’ Survey on acquisition, development, and single-family construction Financing and the Fed Senior Loan Officer Opinion Surve track acquisition, development, and single-family construction lending conditions, the Fed survey includes commercial real estate lending excluded from the National Association of Home Builders measure, most importantly nonresidential construction loans. Illuminating the significance of this difference, summary statistics on the outstanding amount of acquisition, development, and single-family construction loans provided by the Federal Deposit Insurance Corporation indicate that home building construction loans are the smaller portion of all acquisition, development, and single-family construction loans on bank balance sheets, as shown in Figure 2 below. The inclusion of nonresidential construction loans in the Fed’s index and their dominant size over residential construction loans is likely an important factor in the recent divergence.

One caveat in this analysis is that the lending standard surveys are focused on the origination of new loans, while the Federal Deposit Insurance Corporation data captures the yearend stock of loans, reflecting the net flows in (e.g., originations) and flows out of bank loan portfolios over the course of the year. If recent originations, and associated lending standards, in the Fed survey do not reflect the proportions in the current stock of loans, inclusion of the nonresidential construction loans explains less of the divergence.

The role played by regulations imposed by Basel III could be another potential reason for the recent difference in the results of the two surveys. Basel III refers to the significant revisions made to the regulatory capital rules for banking organizations. Basel III introduced the concept of High-Volatility Commercial Real Estate. Under the new rules, High-Volatility Commercial Real Estate was broadly defined as all acquisition, development, and single-family construction commercial real estate loans except one-to-four family residential acquisition, development, and single-family construction loans.

Under the Basel III bank regulations, unless certain exceptions are met*, all loans that meet the definition of High-Volatility Commercial Real Estate are assigned a risk weighting of 150% for risk-based capital purposes. Prior to January 1, 2015, these loans would have typically been assigned a risk weighting of 100%. Loans for 1-4 family residential construction were not included in this higher risk weight category instead requiring a risk weight of 50% or 100%.

To the extent the higher capital requirements dissuade lenders from making High-Volatility Commercial Real Estate loans (and this is reflected in lenders’ responses to the Fed survey), the higher capital requirements could represent an implicit tightening of lending standards, as opposed to an explicit tightening (e.g., higher credit scores, lower LTVs, etc.), and contribute further to the divergence between the two surveys.

Banks, both those with only domestic offices and those with both domestic and foreign offices, report the outstanding amount of High-Volatility Commercial Real Estate in their quarterly reports of condition and income, commonly referred to as “call reports”. Using information in the bank-level data provided by the Federal Financial Institutions Examination Council (FFIEC), Figure 3 below shows the distribution by risk weight of the outstanding amount of High-Volatility Commercial Real Estate loans, both the amount held for sale and the amount of loans and leases net of unearned income.

Consistent with the intent of the new regulations, the majority of High-Volatility Commercial Real Estate loans have a risk weight of 150%. In the first quarter of 2015 89% of the outstanding amount of High-Volatility Commercial Real Estate loans had such a risk weight. By the second quarter of 2015 97% of High-Volatility Commercial Real Estate loans had a risk weight of 150%. The sharp increase in the proportion of High-Volatility Commercial Real Estate loans with a risk-weight of 150% may simply reflect misinterpretation of the definition of High-Volatility Commercial Real Estate loans. The Federal Deposit Insurance Corporation published answers to frequently asked questions dated March 31, 2015. These answers contained specific examples of what loans constituted High-Volatility Commercial Real Estate debt and suggest that there was some confusion regarding the High-Volatility Commercial Real Estate categorization. Since the second quarter of 2015, the share of High-Volatility Commercial Real Estate loans has further concentrated in the 150% risk weight category.

* As discussed by the American Bankers Association, the exclusions to the High-Volatility Commercial Real Estate definition are more nuanced. As they explain, in addition to 1-4 family residential acquisition, development, and single-family construction loans another exception includes commercial real estate loans that meet the following 3 criteria.

1.) Meet applicable regulatory LTV requirements

2.) The borrower has contributed cash to the project of at least 15 percent of the real estate’s “appraised as completed” value prior to the advancement of funds by the bank

3.) The borrower contributed capital is contractually required to remain in the project until the credit facility is converted to permanent financing, sold or paid in full.

** The Federal Deposit Insurance Corporation provides the following definitions for each risk bucket:

0% risk weight – The portion of any High-Volatility Commercial Real Estate exposure that is secured by collateral or has a guarantee that qualifies for the zero percent risk weight. This would include the portion of High-Volatility Commercial Real Estate exposures collateralized by deposits at the reporting institution.

20% risk weight – The portion of any High-Volatility Commercial Real Estate exposure that is secured by collateral or has a guarantee that qualifies for the 20 percent risk weight. This would include the portion of any High-Volatility Commercial Real Estate exposure covered by an Federal Deposit Insurance Corporation loss-sharing agreement.

50% risk weight – The portion of any High-Volatility Commercial Real Estate exposure that is secured by collateral or has a guarantee that qualifies for the 50 percent risk weight.

100% risk weight – The portion of any High-Volatility Commercial Real Estate exposure that is secured by collateral or has a guarantee that qualifies for the 100 percent risk weight.

150% risk weight – High-Volatility Commercial Real Estate exposures, as defined in §.2 of the regulatory capital rules excluding those portions that are covered by qualifying collateral or eligible guarantees.

Application of Other Risk-Weighting Approaches – Any High-Volatility Commercial Real Estate exposure that is secured by qualifying financial collateral that meets the definition of a securitization exposure or is a mutual fund.

Construction Lending on the Rise

Construction Lending on the Rise

One factor holding back a stronger rebound in home construction has been the tight availability of acquisition, development and construction (AD&C) loans. However, recent data confirm that net lending is on the rise.

According to data from the FDIC and NAHB analysis, the outstanding stock of 1-4 unit residential AD&C loans made by FDIC-insured institutions rose by $1.952 billion during the first quarter of 2014, a quarterly increase of 4.46%.

The first quarter expansion of the stock of AD&C loans marked the fourth consecutive quarter of increase. Since the end of the first quarter 2013, the stock of outstanding home building AD&C loans is up 12.2%, an increase of just under $5 billion.

It is worth noting the FDIC data report only the stock of loans, not changes in the underlying flows, so it is an imperfect data source. Nonetheless, the consistent growth in the outstanding stock of AD&C loans is a positive development. NAHB surveys of builders also suggest improving lending conditions.

However, lending remains much reduced from years past. The current stock of existing residential AD&C loans (the blue area on the graph below) of $45.7 billion now stands 77.6% lower (denoted by the red line) than the peak level of AD&C lending of $203.8 billion reached during the first quarter of 2008.

The FDIC data reveal that the total decline from peak lending for home building AD&C loans continues to exceed that of other AD&C loans (nonresidential, land development, and multifamily). Such forms of AD&C lending are off a smaller 61.6% from peak lending. This class of AD&C loans has now registered three quarters of significant increases (1.5% for the first quarter of 2014).

Some land development loans connected to home building are grouped in this other class. NAHB survey data indicate land development loans face tighter lending conditions than loans for residential construction purposes.

Despite the recent uptick in residential AD&C lending, there exists a lending gap between home building demand and available credit. This lending gap is being made up with other sources of capital, including equity, investments from non-FDIC insured institutions and lending from other private sources, which may in some cases offer less favorable terms for home builders than traditional AD&C loans.

Smaller Banks Are the Largest Source of AD&C Lending

Smaller Banks Are the Largest Source of AD&C Lending

Data from the FDIC indicate that smaller financial institutions, typically community banks, are the most common sources of lending for home building acquisition, development and construction (AD&C) loans. This trend strengthened during years of the housing crisis.
The FDIC data are split into two sources: commercial banks and savings institutions. As of the final quarter of 2013, total 1-4 residential construction and development loans held by commercial banks summed to $38.9 billion. Such loans from savings institutions represented a smaller source: $4.8 billion.
With respect to commercial banks, the fourth quarter 2013 FDIC data reveal that 62% of home building AD&C lending was held by banks roughly matching the community bank standard of possessing less than $10 billion in total assets. This lending was decentralized as there are almost 5800 such institutions, although it is not possible to determine how many held residential AD&C loans. In contrast, there were 90 commercial banks with more than $10 billion in assets, holding a still significant $14.7 billion in home building AD&C loans.
Nonresidential AD&C lending, which includes some land development financing and commercial real estate, is more likely to be held by larger banks, as the chart above indicates. In fact, more than half (56%) of such loans were held by commercial banks with more than $10 billion in assets.
A larger share of residential AD&C was held by larger institutions prior to the recession. The chart above notes the change in market share from the end of 2007 to the end of 2013. While the share of nonresidential AD&C held by large banks increased over this six-year period, the market share of residential AD&C shifted to smaller banks. For example, at the end of 2007, 52% of home building AD&C was held by banks with more than $10 billion in assets, a swing of 14 percentage points of market share from 2007 to 2013.
The smaller savings institutions side of the market tells a similar story. At the end of 2013, 86% of home building AD&C loans held by savings institutions was controlled by institutions with less than $5 billion in assets. A noticeable difference is that both residential and nonresidential AD&C lending shifted, in terms of market share, toward smaller savings institutions from the end of 2007 to the end of 2013, as the following chart demonstrates.

Bankers, business leaders say credit crunch is regulators’ fault

Testifying this week before the U.S. House Small Business Committee hearing, bankers and small business owners told lawmakers that a harsh regulatory environment is responsible for the tight business credit market.

“What we found is that the FDIC regulators are inconsistently applying regulations throughout the banking community,” Lynn Ozer, executive vice president of Susquehanna Bank, said in his testimony representing the National Association of Government Guaranteed Lenders.

The hearing focused on the contention from regulators and President Obama that the Federal government does not have any impact on banks’ ability to lend money. Witnesses argued that Federal government regulation is impeding banks’ ability to lend money to businesses.

Source: American Banker