Determinants of Losses on Construction Loans: Bad Loans, Bad Banks, or Bad Markets?

Abstract

Construction loan portfolios have experienced notoriously high loss rates during economic downturns and are a key factor in many bank failures. Yet there has been little research on what drives losses on construction loans and how to mitigate those losses, due to a lack of data. Using proprietary loan-level data from more than 15,000 defaulted construction loans at over 275 banks that failed between 2008 and 2013, we explore the extent to which observed losses during a severe downturn are driven by the characteristics of the loans, the originating banks, and the local markets. We find close ties between loss rates and certain loan characteristics as well as market conditions both at and after origination, while institution-level differences across banks appear less important. We find that the risk of higher losses on construction loans is influenced not only by the originating bank’s behavior but also by the behavior of other local lenders in the market. This finding has important implications for how lenders and regulators manage risk through the real estate cycle. We also find support for existing regulatory guidance regarding higher capital requirements for construction loans, specifically for land and lot development loans.

Keywords: ADC, Construction Loan, LGD, CRE

JEL Classification: R31, R33, G21