Construction financing was the toughest nut to crack in 2008. And it will get no easier in 2009.

The rash of bank failures in the third and fourth quarters included some of the multifamily industry's largest lenders, like Wachovia and Washington Mutual, and many expect more breakdowns in the first half of 2009.

Local and regional banks will continue to conservatively fund some projects in 2009, but preference will be given to developers that have longstanding relationships with those banks. The financial strength and experience of sponsors will be more important than in recent years to procure financing.

The largest remaining lenders are expected to whittle down their commercial real estate exposure in 2009, targeting only the strongest deals. And in late 2008, many banks were earmarking their construction capital to rescue distressed developments, rather than fund new ground-up ventures.

“You're going to see more shrinking of commercial real estate balance sheets on the banking side rather than expansion in 2009,” says Phil Melton, a senior vice president at Grandbridge Real Estate Capital, a subsidiary of BB&T Bank.

Terms tighten

Underwriting standards for construction loans continued to grow more conservative at the end of 2008. Loan-to-value (LTV) ratios dropped from 80 percent to the 70 percent range over the year, and debt-service coverage ratios rose to a minimum 1.25x.

LTV ratios will likely continue to contract in 2009, requiring developers to find more equity to make deals pencil out. But equity providers are now charging upward of 20 percent, a trend likely to worsen in 2009.

Like most banks, KeyBank Real Estate Capital's Income Property Group has grown much more selective in its construction lending. Multifamily is its preferred asset type—about 40 percent of its portfolio is multifamily—even more so now since Fannie Mae and Freddie Mac continue to provide a permanent loan “exit strategy.”

But it will only choose the best projects from developers with whom it has a deep relationship.

“We're going to allocate our capital to drive it to those clients that do everything with us,” says Christa Chambers, a senior vice president of KeyBank's Income Property Group.

The London Interbank Offered Rate (LIBOR), the benchmark used to set construction loans, was about 1.9 percent in early December. Spreads were averaging around 350 basis points, for relatively attractive all-in rates in the mid-5 percent range. “I don't think the risk is being priced, so that's why we need to make it up with deposits or permanent loan fees,” says Chambers.

KeyBank's construction loan volume for commercial real estate was down about 75 percent in 2008 compared with 2007. Like most banks, Key is hoping to hold steady or even whittle down its commercial real estate exposure in 2009.

Some banks have begun offering interest-rate “floors” on a case-by-case basis, to protect their spread and make construction loans a more attractive investment. LIBOR fluctuated wildly over the last year, making floating-rate construction loans very unpredictable.

In December 2007, the 30-day LIBOR averaged 5 percent, but a year later, it was down to around 1.9 percent. So banks are now offering all-in interest-rate floors, which no construction loan can go below regardless of what happens with LIBOR.

Since LIBOR is set by a European banking community that had its share of struggles in 2008, many believe the wild ride is far from over. “The future short-term outlook for LIBOR is questionable,” says David Cardwell, vice president of capital markets at the National Multi Housing Council. “I don't have a lot of confidence in markets that are set by the banks right now.”