“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.”
– Mark Twain
In defense of bankers…in the above referenced deal, Mr. Clemens (as he likely signed) may have agreed to return the umbrella by a certain date, on which it happened to rain. In any event, it’s been sunny these last few years. Are storms on the horizon?
Seniors housing developers are finding it difficult to secure construction financing, despite the fact that most of the projects they’ve delivered recently have leased up quickly. The decision of a bank to lend is based on three primary factors:
- The bank’s assessment of the risk of the deal;
- The bank’s available capital; and
- The bank’s standing with its regulators.
While there is subjectivity to all three of the above considerations, numbers two and three are intertwined, nebulous, and can be unwavering in the face of even the strongest transaction.
Banks are subject to extensive regulation, but the following are likely the most germane to the seniors housing construction business:
- Basel III – The Basel Committee on Banking Supervision (BCBS) consists of 28 voluntary member countries that meet periodically (in Basel, Switzerland) to establish global banking regulatory standards. The BCBS does not enforce these standards, but the member country central banks are expected to do so within their own respective national banking systems. The BCBS has agreed upon three major regulatory standardizations, referred to as Basel I, II, and III, in 1988, 2004, and 2011, respectively. The amount of equity capital a bank must hold was a major focus of all three accords, as equity functions as the buffer between loss and failure. Basel III increased common equity requirements from 2.0% to 4.5% (of risk-based assets). In addition, a 2.5% “capital conservation buffer” will be phased in by 2019, effectively making the base requirement 7.0%. Further, if a bank is considered to be a global systemically important bank (G-SIB, or “too big to fail”), then an additional requirement of 1.0% to 3.5% of capital will be phased in by 2019. JP Morgan Chase, the largest US-based bank, expects its common equity requirement in 2019 to be 10.5% (4.5% + 2.5% + 3.5%), a five-fold increase from the requirements under Basel II. U.S.-based banks have focused on building common equity since 2009 and now average over 12%.
- OCC – The Office of the Comptroller of the Currency, or OCC, is one of the regulatory bodies that monitors bank compliance. According to a July announcement by the OCC, more than 180 banks had doubled their commercial real estate (CRE) exposure in the three years ending 12/31/2015, and that “at the same time we are seeing this high growth, our exams found looser underwriting standards with less-restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements, and deficient-stress testing practices.” Conversely, the Federal Reserve Board’s July 2016 survey of senior loan officers indicated that “significant net fractions of banks reported tightening standards for construction and land development loans.” Despite this, the OCC “has not, however, seen evidence of tightening during supervisory activities to date.”
- HVCRE – A component of Basel III that became effective on January 1, 2015 concerned High Volatility Commercial Real Estate (HVCRE). A construction loan deemed to be financing HVCRE will be assigned a 150% risk rating, which effectively means the bank needs to hold 50% more capital. Banks’ interpretations of what loans to categorize as HVCRE vary widely. The crux of the HVCRE guidance stipulates that borrowers must fund 15% cash equity into a project, or it is considered to be HVCRE. The apparent ambiguity of HVCRE has provided a veil of uncertainty over bank construction lending.
A bank’s noncompliance with regulation can result in consequences that range from restrictions on executive compensation to the implementation of more extensive policies and procedures. While the former will certainly get everyone’s attention, the administrative burden associated with the latter can be extraordinary. Either way, banks are incentivized to comply; many banks prefer halting construction lending to explaining to regulators why they did not do so.
Construction financing in the current market
Smaller, lower leverage, full recourse construction loans are still fairly available provided the guarantee is strong. The remaining construction loan requests are more challenging. For some seniors housing developers, the market opportunity to build is too compelling to wait for the bank construction lending business to emerge from stagnation. These developers have found the following alternative sources:
- Layered financing – Adding a layer of mezzanine debt in between the bank debt and LP equity can effectuate a non-recourse financing without further diluting the GP’s interest. In this circumstance, a bank lends non-recourse at +/-50% of cost, with the mezzanine lender adding debt to bring leverage up to +/- 75% of cost, and the balance is funded with equity. The 50/25 senior/mezzanine debt structure would carry a higher blended rate than a traditional bank loan, but in many instances, non-recourse is more important.
- Debt funds and non-bank financial institutions (NBFIs) – Debt funds and NBFIs are not regulated like depository banks. The terms they offer vary, but some will provide high-leverage non-recourse whole loans. While several of these companies focus on seniors housing, many are agnostic to asset type and therefore lesser known in the seniors space.
- FHA/HUD – The FHA/HUD 232 new construction program is a viable option for developers who are not under immediate time pressures to start building. The process is paper and resource intensive, but is quicker now than at any point in recent memory, and the loan terms are without match (40-year fixed rate, non-recourse).
- Foreign banks – According to the lender survey, “foreign banks reported leaving CRE lending standards basically unchanged.” Indeed, according to CoStar, foreign banks grew their CRE portfolios 7.0%, as compared to just 0.8% for U.S.-based banks during the same time period ending July 27, 2016.
- Conventional bank available capital – A conventional bank’s construction portfolio fluctuates as completed projects are sold or refinanced. A bank may unexpectedly receive a large pay-off, funds which it could then redeploy to new projects.
As long as market fundamentals remain strong, there will be capital available to build. The capital may look different, but it’s there.