Developer Armin Behravan was used to hearing the word “no.”
It was late 2010, and he and a few partners had just paid cash for a four-unit condominium complex in a good part of Santa Monica. They had plans to demolish it, build new units and have them on the market this summer.
“We saw we could buy the property at the bottom, then by the time we permit and build it, it would be two or three years later,” Behravan said. “We bet the market would be back by then.”
But he couldn’t find a bank loan for construction – and not for lack of trying.
“We went to probably 30 banks,” Behravan said. “We thought we were in a pretty good position to get a loan, but the banks were not willing to do anything.”
That’s been a common refrain from local borrowers for the past few years, but one that’s starting to change. In the first quarter, construction lending by Los Angeles County’s banks increased for the first time since 2007. But even as lenders get back into the game, they’re super cautious.
“We’re just re-emerging into that market after getting pounded a little bit,” said Douglas Spencer, chief executive of tiny Fairfax District lender Gilmore Bank, which last year gave Behravan the loan to build the condos. “We felt like this was a place we could play and make some money – with all the conservative caveats we learned in the recession.”
Since 2007, when construction lending peaked, no other type of lending by community banks has fallen so far. At the end of that year, the county’s banks held nearly $16 billion in construction loans – 17 percent of their total loan portfolios, according to the Federal Deposit Insurance Corp. That was nearly twice the level of construction loans banks held at the end of 2000.
After falling steadily for five years, construction loan balances totaled just about $2 billion – or about 2 percent of total loans – at the end of last year. In the first quarter of this year, those numbers increased for the first time, though by a meager $7 million.
The uptick shows banks see an opportunity in issuing construction loans, which have higher yields than less risky loans. But it’s an opportunity they’re only tiptoeing toward.
Banks want more money down, more collateral and more assurances of tenant demand for new buildings. What’s more, many banks simply plan to lend less.
Gilmore is a case study. In 2007, about one-third of the bank’s loan portfolio was in construction projects. Spencer said he doubts Gilmore will ever get back to that level.
“That’s been ratcheted downward quite a bit,” he said. “It’s going to be substantially less than that former number.”
The drop in construction lending has been remarkably steep, with balances falling 87 percent since their peak, and the comeback has taken remarkably long to arrive – at least at community banks.
While construction lending by community banks is only starting to rise, construction borrowing in Los Angeles has been on the upswing for two years. Loans to local borrowers totaled $1.8 billion last year, more than double the 2010 figure of $874 million, according to Irvine real estate research firm CoreLogic Inc., which provides data for the Business Journal’s Econowatch chart. (See page 71.)
That means local developers and business owners have been building, but haven’t been borrowing from local banks.
Loans have come from national banks and from nonbank financiers taking advantage of the dearth of financing options. Over the past few years, Hankey Investment Co. LP, a nonbank lender controlled by local billionaire Don Hankey, has financed the construction of single-family homes in Malibu and Newport Beach, as well as an office-to-apartment conversion on Wilshire Boulevard in Koreatown.
Scott Dobbins, president of Hankey Investment, said those are good projects in stable markets and should provide good returns. Hankey charges higher rates than a bank, but Dobbins said clients have been willing to pay because they haven’t been able to get bank loans. That will likely change as banks return to the market.
“As the economy picks up and banks loosen up, that will create more competition for us,” he said.
Money has come from other sources as well, including private equity groups; Wall Street funds; and even foreign investors seeking U.S. residency through the EB-5 visa program, which provides a green card to immigrants who make a $1 million investment in a new business or a development project.
But now, even community banks that put a full stop on construction projects are re-evaluating that position.
Eddie Kim, chief lending officer at downtown L.A.’s Chinatrust Bank U.S.A., said executives there are starting discussions about returning to construction lending after the long moratorium. But they remain wary.
“The banking community should have learned a major lesson,” he said. “When you look at construction lending, that segment was probably the largest segment that caused losses with the banks.”
Construction loans represented an outsized portion of banks’ losses over the past few years. From 2008 through the end of last year, local banks charged off $7.3 billion in bad loans – 31 percent of that, or $2.3 billion, came from construction loans, according to FDIC figures.
Also, Wade Francis, president of Long Beach bank consultancy Unicon Financial Services Inc., said regulators are taking a harder look at whether banks are following their own rules regarding construction loans. Banks seen as having too many loans in construction or other business lines can be required to perform stress tests or report more information to regulators.
“There’s still more regulatory scrutiny and community bankers are gun shy,” Francis said. “Regulators are looking closely at making sure there’s credit quality.”
In 2006, just as home prices were peaking, the Office of the Comptroller of the Currency, a federal agency that regulates banks, noticed lenders had lots of their assets tied up in commercial real estate and construction loans.
Richard Dixon, assistant deputy comptroller in the agency’s Glendale field office, said the agency didn’t tell banks to lend less but rather to stick to their own internal policies when it came to offering new loans and monitoring ongoing ones.
Construction loans are riskier than other types, in part because their repayment is so closely tied to the real estate market: If property values decline and no investor wants to buy a newly built minimall, for example, the bank could take a hit. What’s more, real estate developers often have other assets tied to the real estate market, meaning assets used as collateral to secure a loan could evaporate in a downturn.
But banks made other risky moves, too, often making exceptions to their own internal guidelines. That included offering loans worth larger and larger percentages of a project’s estimated construction costs or value. Instead of covering 70 percent of construction costs, banks offered loans covering much more.
“Banks establish specific loan-to-value requirements, and that’s what the board thinks is acceptable,” Dixon said. “But to compete with the institution across the street, they’d do 85 percent or 90 percent loan to value.”
Dixon said banks also failed to monitor projects to make sure they were on time and budget, often because they had lent on projects outside of their core service area.
Banks can’t get away with as much today, said Damon Romano, lead senior manager in the Southern California bank auditing practice of Seattle accounting firm Moss Adams LLP.
Regulators want to see that banks have studied the real estate market in areas where they’re lending, that they are working with borrowers who have the means to repay a loan and that they don’t tie themselves so much to the real estate market.
“We’re not going to see the levels of construction lending we saw in 2007 and 2008, Romano said. “It’s a changed regulatory environment. Banks want to make money, but they’re being safer than they’ve ever been.”
But profit is certainly a reason to get back into construction loans. The higher risk on such lending also means higher yields, and that’s attractive to banks as they continue to face low interest margins.
Bankers say they might get an annual rate of 6 percent on a construction loan, a few percentage points higher than on other loan types. Plus, borrowers typically pay an upfront fee of as much as 1 percent of the loan.
“It’s a very attractive all-in interest rate,” said Gary Tenner, an analyst who follows publicly traded community banks for brokerage D.A. Davidson & Co. in Lake Oswego, Ore. “Relative to the pretty skinny rates banks can get today, it’s a net benefit to the average portfolio.”
During the boom, local banks were helping to build single-family homes, condos, retail centers and all types of other properties. And they were helping build them all over the region. Now, they’re much more selective both in the types of projects and their locations.
Among the most attractive property types are owner-occupied buildings. Farmers & Merchants Bank of Long Beach this spring offered $3 million in construction financing to surf wear brand Body Glove International LLC to build a second story atop its original home in Redondo Beach.
The company had been leasing office space but with the addition will be able to move its management staff into its own building – the Dive n’ Surf surf wear shop – and expand its retail space.
Henry Walker, president of Farmers & Merchants, said financing the construction was a relatively easy decision, both because Body Glove has been a bank client since the 1960s and because the project is already leased.
“You don’t have to worry about the marketplace absorbing that inventory,” Walker said. “With owner-user, that’s always a very safe product to move toward.”
It looked so safe that Russ Lesser, Body Glove’s president, said the company started construction three months before the loan was finalized.
After an owner-occupied building, perhaps the next safest bet for banks is a preleased commercial project, though banks today want much firmer commitments than they did years ago, said Jonathan Lee, a vice president of Century City’s George Smith Partners Inc., which arranges financing for developers.
Before the recession, he said developers could secure bank financing for retail and other commercial properties if they had interest from enough tenants to fill half the property. Now, he said banks want more space locked down, and with fully negotiated leases instead of letters of intent.
Jason DiNapoli, president of Century City’s 1st Century Bank, said most of his bank’s construction loans have been for preleased commercial projects or for single-family homes commissioned by wealthy individuals. Like many bankers, he said he’s not interested in anything speculative.
“The ‘If you build it, they will come’ strategy is high risk,” he said. “We avoid loans to speculative developers.”
Still, a handful of banks are more confident even about speculative projects, especially for-sale housing projects. In the past year, Gilmore Bank not only funded the construction of Behravan’s Santa Monica condos – now expected to start selling in the spring – but also three single-family homes being built in Pacific Palisades by West L.A. developer White Picket Fence Inc.
David Carlin, a partner at White Picket Fence, worked with Gilmore before the recession and said the only thing that’s changed is that the bank lent less money this time around – funding about 65 percent of the construction costs instead of 75 percent. That leaves the developer to cover the difference.
Spencer, Gilmore’s chief executive, said the bank has always focused much of its construction lending on residential properties, but that it’s now focusing exclusively on areas where home prices have been stable and high: Santa Monica, Pacific Palisades and other Westside locales.
“In the right neighborhoods, we’ll do spec stuff,” Spencer said.
Though few local banks have followed suit, one recent loan deal shows that banks see rising housing prices and are feeling more comfortable about lending to build houses and condos.
This month, Century City developer Taag Investment Management LLC secured an $11.8 million loan to build 63 condos in Silver Lake. What’s more, the loan is a so-called nonrecourse loan, meaning Taag will pay a slightly higher interest rate but doesn’t have to put its own assets on the line to secure the loan.
In a nonrecourse loan, the developer pledges to complete the project, but the bank can only take back the property – not seek repayment from the developer – if the project sells for less than expected.
George Smith’s Lee, who arranged the financing, said it’s the first nonrecourse loan for condo construction since 2007 in the L.A. area. He said he could not disclose which bank offered the loan, though he confirmed it is a bank headquartered in the county.
A nonrecourse loan, especially on a condo project, is a big deal, said Larry Kosmont, chief executive of downtown L.A. consulting firm Kosmont Cos.
“The thing about the Silver Lake project is that it turns a corner,” he said. “A nonrecourse loan means the bank is back to underwriting the real estate market. It’s past the developer. You’re really betting the real estate market at this point.”
If banks start offering more nonrecourse financing, Taag President Charles Tourtellotte said developers would be more aggressive.
Bad loans hurt many banks, but they also ruined many developers who used personal assets to back up loans. That’s made many developers hesitant to move forward on new projects.
“A repayment guarantee is one thing many builders are less enthusiastic about signing after this last cycle,” Tourtellotte said.
The Taag deal worked in part because the company came to the table with an unusually large investment in the project. While most construction loans fund more than half of construction costs, Taag was looking for a loan to cover just 40 percent.
For now, most banks say nonrecourse lending isn’t part of their plans. Chinatrust’s Kim said banks got lazy or overly optimistic about real estate before the recession and didn’t do enough to make sure borrowers could afford or pay back their loans.
“Before, people only worried about the primary source of repayment – the project itself,” Kim said. “Now, borrowers have to have net worth that banks can lend against or something that suggests we’re dealing with a more substantial borrower.”
Nowadays, Lee said, a community bank wants a developer’s net worth to at least equal the loan they’re seeking as well as liquid assets of perhaps 20 of the loan amount. Banks also want to see sources of income other than construction projects.
“They don’t want you to live off the developer fees you’re collecting,” Lee said.
That’s the difference between today and the boom years, when Lee said developers could secure financing “if they had a pulse and could fog a mirror.”
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