Bank financing is beginning a slow return to the commercial real estate market as healthy financial institutions resolve existing credit issues and �right size� their balance sheets.

Banks that have worked through their credit issues will re-enter the construction financing market when demand for space demonstrates a renewed need for construction. Those looking for financing will find underwriting standards that reflect banks� lower-risk tolerances. Developers will need to adjust return expectations in response to new underwriting requirements.

Healthy banks initiated proactive loan-loss reserves beginning in early 2009. This, in addition to high levels of real estate exposure, created capital issues for commercial banks, prohibiting many from issuing new CRE loans. Strict regulatory limitations also put a damper on new activity.

Strong banks have begun to work through CRE credit issues and will begin to diminish loan-loss provisioning levels as they move rehabilitated credits back to satisfactory performance levels. Banks have also had sufficient time to recognize unsalvageable credits and are moving along the process of disposing of assets. With the work-out process well underway, bankers are shifting their focus from portfolio management to business development.

Britta Evans

As commercial banks cautiously re-enter the CRE market, construction financing will be among the last to rebound due to the risk associated with the product type.

During the height of the most recent real estate boom, most construction projects were financed with a speculative component reliant on the strength of the market to absorb new inventory. Large-scale construction lending will not fully return until the economy has stabilized restoring equilibrium to the leasing market. Businesses need to replace jobs and customers to create demand for vacant space in inventory. Once the market has absorbed existing vacancies we will see a larger appetite for new construction.

Developers need to be aware of underwriting standards that have returned to a more traditional global risk-based analysis. Banks are looking to the certainty of future income streams, and only those that can be absolutely relied upon via credit quality pre-leasing or in-place purchase contracts will be considered sufficient to mitigate market risk. Construction lenders are now underwriting more stringently to end financing in addition to tightening vertical underwriting.

As a result, construction lending will remain limited by activity in the permanent market. Future income streams are being heavily stress-tested for both valuation and repayment purposes. The result is continued pressure on loan sizing, which is currently 50% to 65% loan-to-end value.

Properly structured bank financing is available for projects where downside risk to the lender can be quantified and mitigated. Underwriting standards will force more risk on borrowers via higher equity requirements and full-recourse demands. Bridging the bid-ask gap related to loan sizing is the final piece in restoring bank credit to the market. Developers should expect to rework proformas adjusting risk/return tolerance to determine if projects make sense in the new lending environment.

Banks that have worked through the bulk of their credit issues and maintained appropriate capital levels are currently reviewing construction loan packages.

Speculative financing for projects will likely not be available until existing vacancies have been absorbed, creating demand for new space. Financing packages for pre-leased and pre-sold projects underwritten on conservative parameters, including higher equity requirements to mitigate bank risk, are being considered by banks today.

As the economy continues to improve and lenders are able to place more certainty on end-income streams, leverage will return to a more normalized state and construction lending will again find its way back to the market.

Britta Evans is a vice president in the Investment Real Estate Group with Colorado Business Bank. She has been with Colorado Business Bank since graduating from the University of Denver with a master’s degree in real estate and construction management in 2003.