Securing commercial real estate (CRE) financing in today’s market is no easy task. After the three bank failures this year, which triggered increased regulatory scrutiny of bank-held CRE loans, banks have pulled back on lending. This is especially true for riskier varieties of lending, such as construction loans, which involve assets that are not yet generating income. Many banks are instead choosing to hold onto cash to strengthen their balance sheets, leaving less cash available for lending.

However, there are private lenders with money ready to lend, and they are likely to be an active segment of the CRE lending market, while bank activity remains muted.

“As long as the fear of deposit flight keeps banks on the conservative side of risk management, investors will have an outsized role to play in CRE lending.”

Both the Supply of and Demand for Construction Financing is Drying Up

In April, nearly 75 percent of bank loan officers reported tightened lending standards for construction loans, according to the Federal Reserve’s Senior Loan Officer Opinion Survey (SLOOS). Over the same time, 67 percent of loan officers reported a decline in demand for construction loans, which is a new low for this metric of demand.

The chart below illustrates the tightening supply of construction financing from banks, which is only one portion of the construction lending market, and the sharp decline in construction lending demand from banks. A widening gap between these two measures indicates that both the supply of and demand for construction financing from banks is falling.

Small Banks Account for More Construction Financing than Large Banks

When the Federal Reserve started tracking bank-held construction loans as a separate category within CRE loans in January 2015, small banks accounted for 59 percent of outstanding bank-held construction loans. Since then, small banks have consistently grown their share of the construction financing market, while large banks have generally held back.

By May of this year, small banks accounted for 73 percent of outstanding bank-held construction loans. Though small banks have meaningfully increased construction lending over the last several years, the recent bank failures and general uncertainty in the market may make it difficult for them to continue to lend at the same pace.

Investor Lenders Sit on Record Amount of Dry Powder

While banks have historically been the most active construction lenders, there are other places to get a construction loan. For example, “debt investors” or “investor lenders” lend their own money out. Compared with banks, which lend depositors’ money, investor lenders can generally take on more risk since it’s their own money they would lose if a deal goes bust. These debt investors are sitting on a record amount of debt dry powder (uninvested money that was raised to lend) and will have a role to play in lending markets for both construction loans and mortgages on existing structures.

Sizing Up the CRE Capital Markets

Though the size of private CRE debt funds varies over time, they tend to be larger than CRE equity funds (funds that acquire ownership in the real estate itself, rather than lending against it). This was certainly true in the first quarter this year, when the average debt fund raised was over twice as large as the average equity fund. In the third quarter of 2022, debt fund size decreased by about 75 percent, from $740 million to $185 million. Since then, however, debt funds have been getting larger as equity funds have shrunk in size. Larger funds can write larger checks and therefore fund larger properties or portfolios of properties.

So, What’s the X-Factor?

Investor lenders are sitting on a record amount of debt dry powder as liquidity in other corners of the financial markets has dried up. While not all of that cash will go towards construction financing, investors will have a greater risk appetite than bank loan officers in the current environment. As long as the fear of deposit flight keeps banks on the conservative side of risk management, likely reducing their construction lending business volume, investors will have an outsized role to play in CRE lending. However, borrowers may need to pay meaningfully higher interest rates to compensate private lenders for the increased risk they bear in today’s uncertain economic climate.