Banks Challenged While Construction Loans Hang Around

While this wasn’t a good year for commercial real estate, banks saw commercial loan growth.

These loans — known as CRE loans — were up 3% year over year, while general commercial-industrial loans were down 1%, The Wall Street Journal (WSJ) reported Tuesday (Dec. 26), citing data from the Federal Reserve.

The WSJ report examines this phenomenon, noting that the growth is essentially the result of commitments to commercial projects made prior to this year. Many bank construction loans are designed in a way that the bank pays money increments, at various stages of the project.

Developers will often look for what is known as permanent financing, like a mortgage backed by the new building and the projected revenues from rents or leases. In other cases, there are also bridge loans, which are eventually replaced by another, longer-term mortgage.

“The dirty little secret in commercial real estate is that loans don’t really get repaid,” wrote Autonomous Research analyst Brian Foran in a recent note. “They get refinanced.”

That means commitments still get parceled out, leading to growth in construction loans, but with less permanent financing on tap to lower that lending. Such financing, WSJ said, can be tougher to get, as investors grow more cautious or want to lend at higher rates.

“The final project might be delivered into a setting where values are lower than when the developer started,” Jim Costello, chief economist at MSCI Real Assets, told WSJ.

WSJ said the challenge for banks will be how to treat these ongoing loans across the banking system. Loans to projects run the risk of not being ultimately repaid by permanent financing, forcing banks to become the owner of these projects or sell them at a reduced cost.

Meanwhile, recent PYMNTS Intelligence research shows that the construction industry is plagued by late payments and transaction errors, and days sales outstanding (DSO) — a measurement of how long a company waits to get paid for its products or services — comes in at an astonishing 94 days.

“The downstream ramifications of these payment delays can spell disaster,” PYMNTS wrote earlier this month. “Delays cause cash flow disruptions, resulting in missed paychecks, vendor payments and project delays. New digital technologies are critical to reducing payment delays and bringing greater financial stability to the sector.”

In the U.S., construction sector payment delays contribute to an overall increase of $273 billion in bids and drive up costs across the board.

General contractors and subcontractors raise their bids between 6% and 10% to offset the inevitability of late payments and to keep businesses in the black as they await payment.