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New Construction Needs New Lenders

All across the country, office buildings lie empty. Hotels have closed, some unsure that they will reopen. New constructions have halted, and funding grows scarce. Is this the end of our old way of commercial real estate? Or is it the birth of something new?

The initial shock of the pandemic alarmed professionals across the construction loan industry. Complications resulting from COVID-related restrictions and the work from home shift halted office construction projects—lack of business and vacation travel affected hotels and spaces catering to corporate events. Even if a vaccine were released tomorrow, hesitation among banks and lenders would still fail to return new construction to its pre-pandemic life. So, where does that leave us now?

The Current State of Construction Lending

Currently, market forecasts predict a 10.5% decline annually in effective rents in the top 79 metro office markets. Compared to the decrease in 2009, which was 8.9%, the figure initially looks alarming. However, not all cities across the country will be affected equally. 

For example, the areas predicted to perform worse are predominantly metro areas experiencing a high number of COVID-19 cases. Many are also affected by strict lockdown measures. Other cities with slower expected recoveries include those experiencing difficulty containing their outbreaks.

How the markets respond following the pandemic depends on how cities maintain their control over the virus. Lenders will undoubtedly resume activities sooner in areas with greater control over the outbreak first. Other contenders include those with reliable data on their recoveries and plans to manage the virus's spread. 

In the same respect, a lack of reliable reporting could hurt some areas' chances of receiving funding. Traditional lenders are naturally cautious as they do not have the data they need to predict whether borrowers can repay. While alternative lenders offering construction loans may have more flexible criteria for borrowers, they too are moving forward with caution.

Who Else Is Affected By The New Construction Slump?

Much like office construction, COVID-19 sideswiped the tourism industry. While cities' initial restrictions have lifted, many now reimposed rules or bans on travel to contain the virus's spread. Personal travel is at a comparative standstill and business events have opted to go virtual. Now, even corporate events no longer guarantee hotel bookings. 

The concern over having many people in closed space drives similar worries for multifamily housing. Shortages in labor and construction materials that affected the industry early on have lessened. Now, lenders' concerns look to the long-term feasibility of traditional multifamily housing. 

What Will The Future Look Like?

Does this mean that the new construction market will not recover? Not necessarily. The recovery will not result in the same kinds of projects seen before the outbreak but will offer new opportunities to lenders willing to take the risk. 

For example, in the 1980s, the savings and loan crisis toppled the commercial real estate market. However, as a response, mortgage-backed securities were born. The dot com boom and its subsequent collapse impacted Silicon Valley's commercial property value even harder than COVID. These events are nothing new to finance. However, reliable data is currently scarce; the lenders that lead the recovery will have to make the best of the information they have and think differently about who they fund.

As mentioned, previously safe construction investments such as multifamily housing have lost their appeal to lenders. Renters are struggling with their payments, and those who can buy are moving to less densely-populated areas.

Even those living in apartments will still need housing, and more people than ever can benefit from more affordable options. While this does not mean multifamily construction will continue as it was before the pandemic, it does mean that its next steps will follow a different path. Affordable multifamily housing must be a priority and must involve other options apart from traditional apartment buildings.

What Are Construction Lending's Options? 

One possible option is modular housing, which has a far lower overall cost and quicker construction time than standard apartment buildings. However, borrowers for modular multifamily units typically require more capital upfront. Their increased need rules out financing options with many traditional lenders. 

Since most modular construction happens in the company's warehouse, lenders cannot assess the projects as easily as they would with standard apartments. Many are concerned about their ability to ensure that builders are meeting their milestones in the planned timeline. Since modular multifamily housing is relatively new, assessing property value poses another challenge.

Similarly, eco-friendly construction projects present new risks and opportunities to lenders. Updated ventilation and climate control methods prevent future virus outbreaks and reduce the buildings' overall carbon footprints. Additionally, lenders can bank on borrowers' increased ability to repay due to decreased costs over time. 

What Has to Change For Construction Lending's Survival?

In order to construct buildings that will survive this pandemic and future unknowns, they must be built with personal and environmental safety in mind. This shift also means older buildings with closed spaces and poor ventilation will have to be retrofitted to stay in use. To make heating and cooling more efficient, current office buildings are tightly sealed to prevent air leakage. Now, buildings need to heat and cool efficiently while also permitting airflow. 

Despite all the recent changes in construction, traditional lenders and banks still have to adhere to pre-COVID regulations. Though construction's needs are changing, the rigidity of their system makes it hard to accommodate them. There is still not enough data on the kinds of projects that will lead the recovery for them to make it usable. Further bumps in the road may also. So, where does this leave us?

What Does This Mean for Alternative Lenders?

Alternative lenders face a tremendous opportunity. In areas where traditional lending falls short, they can afford more flexible terms and finance projects that will weather future challenges. This is not, however, to say that they should approach the situation without examining new risks. Lenders should pay close attention to the areas in which borrowers plan to build and how its reopening has progressed. Additionally, the number of businesses shifting to permanent distance work may affect even the most promising locations.

So, where does that leave the industry now? Ultimately, lenders will have to open themselves to new opportunities and risks, finding different ways to assess borrowers and evaluate risk. Much like the response to former crises, legislation may change to make it easier for lenders to finance future projects that aid in the recovery. 

Closing Notes

When pressed by the need to finance new projects, governments, borrowers, and lenders will have to come together on a plan to address the change. While traditional loans may not be feasible, changes in the industry and new ideas from alternative lenders provide much-needed opportunities. Work, travel, and life at home may not be the same, but the most crucial place to look is the future. How can we embrace the change in a way that moves us forward? Alternative lenders will ultimately be those who decide.

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