Thursday, July 16, 2009

Why Haven’t There Been More Construction Loan Defaults?

Delinquency rates for CRE construction loans are “only” 12%; why is that?

Distressed Volatility quotes testimony from Richard Parkus - Head of CMBS and ABS Synthetics Research, Deutsche Bank (italics mine):

90+ day delinquency rates are currently in the 12% range for construction loans in bank portfolios, but are somewhat higher for construction loans in regional bank portfolios. In fact, I am perplexed by the fact that construction loan delinquency rates are only 12% at this point. However, I believe that this can be explained by the fact that they are typically structured with interest reserves which are sufficient to cover interest payments until the expected completion of the project. Thus, construction loan delinquency rates are currently artificially low due to interest reserves, but will likely rise dramatically within the coming 6-12 months. In my view, losses on construction loans are likely to be in excess of 25%, possibly well in excess, which would imply losses of at least $140 billion. This, of course, would be disproportionately borne by regional and local banks."

I agree with Parkus that interest reserves are responsible for keeping these loans afloat. Most construction loans are indexed to LIBOR, or less commonly, Prime. This chart from shows what has happened to these rates:


Construction loans started in 2005 or earlier were mostly refinanced before CRE permanent lenders pulled back, and CRE construction lending declined dramatically during 2008. As a result, the construction loans still out there were originated most during 2006 through the first half of 2008 (the period inside the ellipse on the chart above). The interest reserves on these deals were sized assuming prime would remain around 8%, and LIBOR would be at around 5%. Since then, prime has dropped to 3.25% and 1 month LIBOR is 0.29%. As a result, an interest reserve sized to carry a loan for two years can now cover interest costs for four years or more. So, even though projects are not hitting the occupancy and rent levels projected, many lenders are willing to extend these loans because the interest can be kept current from the original interest reserve without increasing the loan commitment. The hope is markets will recover before the reserve runs out or interest rates go up.