Construction Loan Defaults Are On The Rise

April 28, 2008
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Problems within the construction loan category started to emerge in late 2006 for many of the smaller banks in Michigan and throughout the Midwest, and it took about a year for it to become an issue for banks on a national basis.

The losses picked up in the latter part of last year and will probably continue to increase throughout this year, according to Terry McEvoy, a bank analyst with Oppenheimer Co. The problem has been concentrated in the residential construction market, but that could change.

“We haven’t seen much deterioration on the commercial side, but it’s only a matter of time before the asset quality problems mire into more traditional real estate projects, which would be strip malls, offices, hotels, etc.,” McEvoy said. “It’s really a function of the economy, and if the economy gets any weaker, that’s going to be the next area of stress for the banking sector. Unfortunately, in many instances, it’s a much larger percentage of the loan portfolio, so the losses themselves will be very noticeable.”

A nationwide study by Foresight Analytics LLC shows the overall delinquency rate for commercial construction loans started trending upward in mid-2006 and has continued to climb for every type of construction loan — single family, apartment, condominium and non-residential commercial — for each of the last six quarters.

In the fourth quarter of last year, total construction loan delinquencies jumped to 4.8 percent, up from 3.2 percent in the third quarter, and up from 2.3 percent in the second quarter, Foresight data indicate. The delinquency rate of non-accrual construction loans — those no longer accruing interest — doubled during the fourth quarter of 2007, to 3.2 percent. 

“This sector has experienced the most rapid erosion of any area of real estate-related lending,” Foresight analysts wrote. “Clearly, the deterioration in for-sale housing markets — both single family and condominiums — is having a major impact.”

The delinquency rate for non-residential commercial construction loans increased to 2.2 percent in the fourth quarter of 2007, up from 1.7 percent in the third quarter and 1.3 percent in the second quarter.

The Michigan Department of Labor’s Office of Financial and Insurance Services has compiled data, as well. Spokesman Jason Moon said that last year, 10.7 percent of all the money in construction loans in Michigan was in some form of delinquency, up from 2.6 percent in 2006. 

“This is a sign of the struggling economy,” Moon said. “Because of Michigan’s past history of having a fluctuating economy, we think Michigan bankers are more prepared to deal with this.”

Gail Madziar, vice president of communications for the Michigan Bankers Association, sees it the same way. 

“I would expect as the economy waxes and wanes, so do the delinquencies. I can tell you that our banks are used to managing those kinds of fluctuations in the economy and our banks are highly regulated and well managed,” Madziar remarked. “Of course they’re concerned about any delinquency, but I haven’t heard that they are any more concerned about construction loan delinquencies than any other type of delinquency.”

Many construction loans are made by small and mid-sized banks. Bank Analyst Stephen Geyen of Stifel Nicolaus said those banks should be concerned about the rising volume of defaults. Among the Midwest banks that Geyen covers, a number that operate in Michigan have seen substantial increases in loan defaults.

“It has been two to three quarters in the making for a lot of banks in Michigan that we cover,” Geyen said. “We’ve seen the increase, and it’s primarily coming from residential construction loans.”

If builders are unable to sell houses, those loans could fall deeper into delinquency. Like other analysts, Geyen doesn’t foresee any quick turnaround in the housing market. He said it’s a question of how long the owners of these properties can hang on if they don’t have multiple sources of income to support the property until it becomes a viable project again.

“That’s the question for a lot of these individual property owners, and the question for banks is, how long do they want to hold on to the loans that go into default,” Geyen said. “There is quite a long period in which they need to hold on to that property in order to sell it, so the period of time the loan remains on the books at the banks has stretched out because of the current conditions of the market.”

Geyen said there’s already evidence that banks are pulling back on the volume of construction loans and have become much more restrictive in regard to what kinds of projects they’re willing to fund, specifically the projects related to residential construction.

“Some of the projects related to commercial development are still moving — the banks are still moving forward on those, but they’re looking even closer at those loans before they decide to fund them,” Geyen observed. “But for the projects related to residential construction, new funding has diminished greatly in the last couple of quarters and will continue to in the next couple of quarters.”

McEvoy, too, expects to see a pull-back in the volume of construction loans this year, both in terms of demand and supply.

“What developers are left are very conservative, and they’re not taking on new projects; they’re simply working through the developments they have that have yet to be completed,” McEvoy said. CQX

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