Construction Financing in 2024: Are Banks Lending?

PUBLISHED JANUARY 2024

As a banker and career commercial lender, I can tell you bankers want to figure out a way to lend. The bottom line is that is how we make money! However, we have to weigh the risks of lending in a certain environment (which includes many factors) with the ability to make a sound loan. We are certainly coming off a slower year in construction lending in 2023, so how will this play out in 2024? 

First, I want to touch on some differences I have seen between now and the recession we had in 2008. For many years after the 2008 recession, it was a very difficult market to lend because of an oversupply of residential-development lots and commercial developments, most of which were declining in value. Today, we are in a much different scenario. On the residential side, the supply is limited, and for now, the values are stable to increasing. The commercial sector has different challenges, which I will mention later.

To the credit of the construction industry, as compared to the years leading up to 2008, I believe many of the builders have been at the forefront of being conservative in this market. They have been careful, not wanting to get caught in the same situation holding inventory, so the numbers of developed lots and spec homes have been greatly reduced. This was evident as mortgage rates increased—it has been, and it is now, a lot harder to qualify the average consumer for an end loan. 

For most of 2023, banks focused on their liquidity positions and maintaining strong asset quality. The result was a more conservative approach to lending. Underwriting a new project became more difficult for a couple of reasons as the two main components of underwriting a construction loan came under pressure: 1) Costs for materials and labor continued to increase, and 2) Substantially higher financing costs made it even tougher. 

Most construction financing is based upon a spread over a short-term floating rate index, such as the prime lending rate. As we have seen, this rate increased to its highest level in over 20 years during 2023 to 8.5 percent. That, combined with material and labor costs, requires the banks to look hard at how much they are able to lend on a new project. Overall equity (capital) required to make a project work has become more important, so the borrower that may have been used to contributing 20-25 percent equity into a project may be asked to contribute 35-40 percent equity. This certainly has a negative effect on the ability and willingness to make a new project work. 

What is in store for 2024? I think initially we will probably see much of the same conservative outlook from banks, as we all get used to a higher interest-rate environment. Initial market sentiment is that 2024 could see possible short-term rate reductions, which seems to be possible as we see more stability with inflation. If rate reductions coupled with more stable costs are seen, we could see a nice rebound in several sectors of construction lending. I think these will be led by some pent-up demand in both residential single-family and multifamily projects. Being able to gauge costs more effectively and feel more confident with end financing for either single or multifamily should result in a better environment for residential construction.

Commercial construction financing faces other challenges, which could continue limited construction for 2024 and beyond. Economics 101, supply v. demand, is the challenge. We continue to see a reduction in demand for the amount of both office and retail space. We have seen how the past several years have changed office space requirements and consumer shopping habits. With this change, the need for more of this type of space will be limited. I don’t think all is lost here; if the economy maintains, there will certainly be some need for what I will call neighborhood retail/office. This would include smaller projects of 10,000 to 20,000 square feet in size. As demand shifts in certain markets, you could see an uptick in new commercial construction to fill these needs. 

The strength of the 2024 economy will depend on the status of inflation, which impacts interest rates and costs. This will ultimately affect bankers’ ability to underwrite and finance construction lending in the coming year. However, in order to sustain construction growth beyond the next several years, I believe there are bigger macro challenges. These include controlling our national debt and the ability of our government to balance a budget. The national debt and uncontrollable government spending contributed in large part to our recent inflationary environment, triggering a sudden spike in interest rates. The current trend of increasing debt and deficit spending is unsustainable. This will continue to contribute to uncertain times, which will affect future construction projects and our ability to grow long-term.