"Why banks are pulling back in construction lending, leaving a gap in the market as capital markets shift post-pandemic?"
This used to be an easy question...
----- 2021 answer -----
There are five types of lenders: Banks, insurance companies, CMBS, agencies, and debt funds.
Only two of them tend to provide construction financing: Banks and debt funds. Banks account for more than 40% of the CRE debt markets. Debt funds account for about 4%.
Banks have historically dominated the construction loan market, in part because development loans line up well with banks' structural advantages...
- Short-term loans keep banks from getting too long in duration, avoiding asset/liability mismatches.
- Development loans often yield 100+ bps higher coupons than other loans, which helps bank net interest margins.
- Construction loan coupons typically float over SOFR or Prime, which mitigates bank exposure to rising rates, where they'd have to pay high deposit rates with long-term low coupons on their loan book.
- Banks thrive by being highly local. Most construction lending is done by local and regional banks, and they focus on deposits, local knowledge, and recourse obligations.
These conditions have generally given banks advantages in the construction lending space over insurance companies, debt funds, etc.
----- 2023 answer -----
Short answer: In a normal environment, I'd say "banks", but in today's environment, I'd say "maybe no one."
Long answer: The Covid aftershocks have been brutally painful for banks. They've massively disrupted the capital markets, and construction lending is a clear casualty.
Banks saw a $4+ trillion increase in deposits during the pandemic. Since there wasn't much lending going on since the underlying economy was inactive, they invested much of that extra cash in safe, long-term debt instruments. Nothing wrong with this approach, except that these cash-rich banks were competing with the Fed and its bottomless balance sheet.
Faced with a once-in-a-hundred-years crisis, the Fed was dedicated to stimulating economic activity, and they wanted to keep interest rates low. So they bought billions of Treasury bonds and mortgage bonds, which dramatically affected debt markets and asset values (especially real estate). Bank balance sheets migrated to lower yields and longer durations.
The Fed reversed course in early 2022 by hiking rates and selling the bonds they'd been buying (technically letting them roll off but with the same effect as selling). This had an extremely detrimental effect on bank balance sheets and, on paper, made many of them insolvent.
Nearly every bank pivoted from risk on to risk off (overnight) when SVB failed, and structurally, they're just trying to stay alive and relevant. The impacts of this shift would be very difficult to overstate.
Therefore, although I'd say banks are still the most likely lender type to provide construction financing, there's perhaps a more relevant question: "Is anyone a reasonably-priced construction lender?"
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