Bill Tryon

Many lenders have turned to construction lending in the search for increased yield but increasing uncertainties have made it harder to predict and manage construction risks. Development is still thriving, and there is no shortage of construction projects available for financing; however, developers and lenders are becoming more cautious. Strategies to control spiraling costs, completion delays and other sources of default have become even more important in underwriting and managing new construction loans.

Construction Market Overview

Overall, the fundamentals of the construction landscape look steady through 2019, but caution is creeping in, with headwinds that could slow the industry down significantly past 2020. Economic indicators are flashing signs of a slowing economy. The Commerce Department announced that the economy grew at an annual rate of 2.2 percent for the fourth quarter last year, revised down from its original estimate of 2.6 percent, and the Federal Reserve has lowered their forecast for growth in 2019 and beyond. Most recently, bonds have flashed an even more dire warning, as the 3-month yield curve topped the 10-year rate by the most since the 2008 financial crisis. Though the US recently reversed tariffs on steel and aluminum from Canada and Mexico, new tariffs imposed on Chinese goods are expected to further exacerbate construction cost increases. Compounded with continuing labor shortages, an increase in raw material costs, and the continued project delays being reported, these uncertainties have greatly raised the possibility of a downturn over the next 16 months.

Construction industry indicators also show signs of a slowdown. For the first time since 2012, the March Architectural Billings Index (ABI) dipped below 50, indicating lower billings than the previous month. Though April's index showed billings approximately flat only the Southern region really remains in positive territory. The ABI is generally considered to be a 10-month leading indicator of construction volume, indicating a possible slow down early in 2020. Dodge Data and Analytics also reported a 15% seasonally adjusted annual pullback of new construction start value in April, as well as a slight decline in their Dodge Momentum Index.

On the positive side, the Construction Confidence Index report published by Associated Builders and Contractors (ABC) in May shows continued optimism among contractors, with approximately 75% expecting continued increases in volume. Institutional investors still report lots of “dry powder” to support the right investment opportunities, and Opportunity Zone tax incentives are expected to contribute to development, with potentially billions of dollars of investment infusion

Construction Lending: Steady, But Cautious

The latest indicators from the Federal Reserve's Beige Book, a bimonthly summary and analysis of economic activity and conditions across 12 United States Federal Reserve Districts, confirm a modestly expanding economy, but some emerging headwinds that might impact construction lending. All Districts reported either modest strengthening or steady continuation of economic activity, though with mixed consumer spending and trade-related uncertainty. While employment continues to be robust, a majority of Districts cited shortages of skilled laborers, mostly in manufacturing and construction. Materials costs rose overall, with the biggest increases being noted in metal prices, while lumber prices have continued to decrease over the last few months. Construction firms across most Districts reported a net overall increase in material costs, with several reporting passing those costs on to their customers. The commercial real estate outlook remains positive, with particularly strong fundamentals on the West Coast and Southeast.

A survey of top construction lenders in the industry was recently conducted by the Construction Lender Risk Management Roundtable forum. The survey reflects market status and general consensus of industry health and areas of concern, while year-over-year data points to major changes and trends. This year, the survey included live on-site polling at the 2019 Annual Meeting in San Antonio.

In general, construction lenders' sentiments about project quality, volume and market stability echo the national trends reported in the Beige Book.

Project quality trend – Reported to be stable, and about the same as last year. Fewer lenders reported deteriorating quality, and that's a good thing, but not necessarily a clear long-term indicator. This is a likely reflection of continued development opportunities and a backlog of volume being reported by firms, even Amid a slight slowing in lending volume.

Underwriting exceptions – Lenders report increased underwriting exceptions vs. 2018, generally indicating increased competition and appetite for risk.

Frequency of disbursement exceptions. Overall data on exceptions is similar to last year, with fewer people reporting an increase, and more reporting about the same.

On time completion – Lenders are reporting a slight increase in project delays, with many projects not being completed on schedule and/or missing completion milestones. Though the change is small, 2018 reports of significant delays were at an all-time high, so any increase represents a significant red flag.

Construction Risk Management requirements – Most lenders require pre-loan review of plans and budgets and construction progress monitoring (CPM) and funds control during construction. Bonds are also used to help assure completion of the construction projects.

Reduce Risk Through Construction Risk Management

As growing materials costs drain profit from projects, an increase in contractor and subcontractor failure is increasingly likely. The increased cost to the developer may also result in a substitution of materials (particularly if tariffs create a paucity of availability) and/or passing of cost to consumers and clients. Project delays can also lead to increased costs (compounding the above effects) with impacts like increased interest and management fees. In the rush to participate in rising markets, developers may rush projects on the front end, while contractors may take on too many projects or projects outside their realm of expertise. These situations result in a greater potential for failures, which in turn necessitates greater construction risk management oversight and funds control.

For construction lenders, understanding construction budgets and keeping payments in line with progress is increasingly important during this time of rising uncertainty. Construction risk management services can prevent or mitigate the biggest risks of construction lending (subcontractor defaults, running over budget, missed schedule milestones, etc.). These include contractor evaluations, budget reviews, document and cost reviews, construction progress monitoring and construction completion commitment.