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Nonresidential construction activity cannot recover on a complete and sustained basis without the reengagement of capital markets in the creation of commercial real estate (CRE) and construction loans. That reengagement is likely to occur only gradually, in part because some research has made bankers more circumspect regarding real estate lending.

A recent study undertaken by two Federal Reserve Board economists exploring the determinants of community bank profitability from 1992 to 2010 found that a number of bank characteristics strongly correlate with performance. For instance, community banks with higher portfolio shares of real estate loans earn significantly lower profits—hence the recent preoccupation among many of these banks with expanding their portfolio of commercial and industrial loans as opposed to lending to real estate.

On the other hand, the research indicates that those with higher portfolio shares of construction loans earned higher profits through most of the study period. (Not surprisingly, that relationship did not hold true between 2008 and 2010.)

Despite a set of negative experiences among lenders in recent years, a growing body of evidence indicates credit availability is becoming more common in CRE contexts. According to the Federal Reserve’s January 2014 Senior Loan Office Opinion Survey on Bank Lending Practices, U.S. institutions have eased standards for most forms of CRE loans, leading to stronger demand for such loans.

Additionally, the 2013 Survey of Credit Underwriting Practices, published by the Treasury Department’s Office of the Comptroller of the Currency, determined 24 percent of banks offering non-construction CRE loans had eased their lending standards compared to a year prior, while only 8 percent had tightened standards.

While CRE lending appears to be responding to improving economic fundamentals, including positive net absorption in most office and retail markets across the country, construction lending has been slower to recover. According to Deloitte, last year’s broad-based recovery in CRE financing will likely continue in 2014, but construction loans will remain difficult to obtain. Deloitte indicates construction financing will be increasingly available from non-bank lenders, including hedge funds, which will “continue to extend construction loan funding to mid-market companies.”

Deloitte’s analysts also agree the CRE lending landscape is more stable relative to a year ago, “with lenders increasing commercial mortgage issuances due to the improving economy and rising property prices.”

Interestingly, life insurance companies and government-sponsored enterprises continued to lead commercial mortgage originations through much of 2013, though banks are now willing to “accept higher loan-to-value ratios for CRE loans.”

Data from the Mortgage Bankers Association are consistent with the notion that banks are beginning to play a larger and more traditional role. According to the association, loans for multifamily properties rose 31 percent during a recent 12-month period. Bank lending also rose for hotel (13 percent) and warehouse properties (1 percent). But as a reflection of the sporadic and halting nature of the broader economic and nonresidential construction recoveries, loans for office properties fell 2 percent and those in the retail category slipped 19 percent despite ongoing increases in consumer spending.

Most remarkably, lending for health care properties fell 27 percent, perhaps due to uncertainty stemming from the financial implications of the Patient Protection and Affordable Care Act.

These data help highlight how important non-bank lenders have become. Despite evidence that bank lending remains constrained in office and a number of other categories, spending on office construction expanded 11 percent between January 2013 and January 2014, while commercial construction (primarily retail) was up more than 12 percent.

The nearly unanimous opinion of economists and other analysts is that financing will become increasingly available to CRE buyers and operators this year. However, construction financing will remain more difficult to obtain, particularly for subcontractors given expectations of significant firm failure this year. Construction firm failure occurs frequently during the early stages of industry recovery, as many companies tend to take on new projects without sufficient working or surplus capital. In turn, that causes banks and other financiers to remain hesitant to extend credit to smaller and emerging contractors.

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