A multifamily workforce housing project in downtown Reno that is just getting completed at 110 River Rock. This is a partnership with the City of Reno downtown redevelopment. Heritage Bank provided project funding.
The high interest rate environment of the past few years has led to some big changes in regional construction lending.
Local banking executives told NNBW that as interest rates spiked and the cost of borrowing increased, they began to more closely scrutinize potential construction projects, along with the developer’s track record. Oftentimes, they added, regional developers have been required to put much more skin into a project than in the past in order to obtain construction loans.
“It has had a pretty material impact,” said Tom Traficanti, president of Heritage Bank of Nevada during an interview at the bank’s flagship location on South Virginia Street in Reno. “Construction loans are an important part of what we do, and we have a good reputation with a local disbursement of the area’s commercial construction lending.”
Higher interest rates and the increased cost of capital have changed banks’ underwriting standards. In addition to being more cautious, banks are limiting their total volume of commercial lending across various sectors of commercial real estate in an effort to reduce concentration risk.
“At the top level, we look at whether this is an investment property, or whether it’s someone who's going to be dependent upon the property’s rents and cash flows,” Traficanti said. “We actually do more loans for local business owners who are building a medical office where the repayment is coming from the cash flow of the business itself, which is not looking at the commercial real estate market so much as the business and its underlying reputation.”
Traficanti said about half of commercial loans issued at Heritage Bank are to investors building industrial or multifamily projects. Many of those projects were qualified in a lower interest rate environment, however, and the dynamics have changed drastically over the past 18 months after the Federal Reserve completed the last of 11 interest rate hikes from early 2022 through mid 2023.
Investors trying to pencil projects in 2024 oftentimes qualify for substantially lower loans, Traficanti said, and they require a much greater capital investment. That’s led to fewer construction loans overall since investors are hesitant to take on the added debt and risk.
“The willingness of investors to put that much capital into a project when they maybe can get a better return on alternative investments or other ventures just doesn’t make sense,” Traficanti said. “It certainly does impair our ability to do commercial loans. We are starting to feel the impact of (investors) pulling back because of interest rates.”
Historically, Traficanti noted, banks were able to underwrite construction loans if developers or investors ponied up between 20 to 30 percent of the project’s total cost. That equity number has spiked to between 45 and 50 percent, Traficanti told NNBW.
It’s a lift some investors or developers aren’t willing or able to bear, he added.
“That could be a significant amount of cash when you are talking about a multi-million-dollar property,” Traficanti said. “A lot of developers that have been working on properties are trying to get investors to come in, and that scenario also made it much more difficult.”
The challenges associated with a high interest rate environment haven’t significantly slowed growth in Northern Nevada. Reno’s highly diversified economy remains strong, and over the past decade the Biggest Little City has essentially shifted from a tertiary to a secondary market for investment capital and development of commercial real estate.
“Our market economy here is shockingly strong,” Traficanti said. “I’ve been in the business for more than 30 years and have gone through all the ups and downs. The whole Reno area has really just moved to another level.”
Reno may no longer be such a small town that business gets done with a handshake, but banking history still counts when it comes to construction lending. Longevity and a history of successfully completed projects carries a great deal of cachet at regional banks.
“There’s so many pieces to a construction project, and a developer really has to have their arms around it,” Traficanti said. “The other component to this whole problem was construction costs and being able to manage the smaller subcontractor base that's here. Having those relationships and reputation, as well as the relationship with the bank, is certainly important and does go a long way.”
Matt Baca, vice president of commercial lending with Plumas Bank, told NNBW that although Plumas Bank continues to issue construction loans, he’s seen more and more projects put on hold due to rising equity requirements, higher capital and construction costs, and a shortfall of construction labor and materials, especially in the years following the COVID-19 pandemic.
That caused a bottleneck with construction projects, Baca said, as well as affected their financial feasibility in some instances. Banks often had to change loan dynamics as a result.
“Banks are now having to build in a longer-term interest reserve,” Baca said. “Say it’s normally 12 months, but now I'm building it at 18 months for the construction with an interest reserve that can facilitate the payments as you're drawing on your construction loan.”
While many lenders have turned off the spigot for construction lending, Plumas Bank has continued to fund projects.
“We've stayed on a pretty straight path,” Baca said. “We're very community oriented, and if the project makes sense and benefits the community and the borrower, we're always looking at those transactions.
“We never turned off any of our lending buckets because we never had an over-concentration,” he added. “We're still looking at them – maybe a little bit more closely, but so is every other lender. We are deeply invested in our communities, and we have a good handle on the projects that we're doing.”