This piece originally appeared in the August 2023 edition of MortgagePoint magazine.
In The Book of Tea, Japanese scholar and artist Kakuzō Okakura wrote, “The art of life lies in a constant readjustment to our surroundings.” Truth be told, the “art” of originating mortgages isn’t much different—especially nowadays, when higher rates are forcing lenders to think outside the box to stay in business.
While most banks and independent mortgage bankers are still in cost-cutting mode, construction-to-permanent loans represent an ideal opportunity to make up for lost volume. In fact, the future for this product segment has rarely been brighter.
Why the Timing Is Right for Construction Lending
There are several reasons why construction loan opportunities are growing, and why a growing number of lenders are already receiving positive results. Zillow reports that the United States needs 4.3 million more homes, and other sources estimate that number to be even higher. With inventory at an all-time low, homebuyers are increasingly finding that their best option to get into a home is with new construction.
In fact, builder confidence has started to rise, according to the National Association of Home Builders (NAHB), citing “solid demand, a lack of existing inventory, and improving supply chain efficiency” as the reasons that helped shift the June builder confidence index into positive territory for the first time in 11 months. The new home construction industry is beginning to thrive, creating an environment ripe with potential for independent mortgage bankers and mortgage lenders.
According to a recent S&P Global Market Intelligence report, this past year saw an 18% annual increase in residential construction loans, the largest annual jump since 2016. Meanwhile, U.S. Census Bureau data points to more good news: housing starts surged 21.7% between April and May, the fastest pace in over a year.
This confluence of trends presents a potent opportunity for lenders to essentially signal a green light for those considering launching or expanding their construction-to- permanent loan programs. It’s not just a viable business opportunity, it is also a strategic move that could significantly boost a lender’s portfolio—as long as they have the right tools and resources in place.
It is important to remember that while existing home mortgage origination volumes have increased slightly, it is still a seller’s market. And with rates significantly higher than they were a year ago, fewer would-be sellers are keen to trade their 3% rate loan for a 7% rate. On the other hand, buyers of new construction do not have to settle for the low inventory that currently exists—plus they can avoid getting dragged into a costly bidding war for a home in need of renovation.
The U.S. is experiencing a housing shortage of epic proportions that has only grown more acute over the past year. Despite the building industry’s optimism, research from the National Association of Realtors (NAR) has found that the United States is not building enough homes to keep up with new household formations. We are in a deficit, and it appears to only be getting deeper. In June, the group reported that the nation’s low housing inventory is hurting middle-income buyers more than any other group.
In other words, a serious construction boom is not only very likely but incredibly necessary. Mortgage lenders who already have construction lending programs will be in the right position in the coming months.
And those who do not still have time to learn about and begin construction lending, even though construction loans are not as simple as the average 30-year fixed product.
Considerations for Successful Construction Lending
There are many benefits to offering construction-to-permanent loans, including the ability to generate net interest income, which can be used to enhance profitability and generate more efficient operations and fuel other areas of a lender’s business.
The problem? Traditionally, originating construction-to-permanent loans is both messy and risky, which often severely impacts the lender and the borrower’s experience.
This typically occurs because of a lack of mentors in the construction lending space and a missing understanding of the tools, processes, and software that would help construction programs to be successful.
For example, for a single construction loan, many lenders rely on a combination of software, spreadsheets, and email to manage draw requests, disbursements, project inspections, and other aspects of the construction process.
This lack of cohesion often creates an overabundance of manual work, such as checking and rechecking to confirm when funds were sent and received. It also makes the origination process more frustrating and time-consuming for everybody—not just for borrowers, but for builders and other parties as well.
Take inspection reports, for example. In many cases, a lender’s staff must log into multiple systems to order an inspection and then, when it comes in, they must manually cross-reference the report with the draw request and project budget. Often, they must use multiple computer screens. This type of scenario can add days and errors to the overall process.
Constantly Shifting Rules
There is yet another problem lenders looking to boost volume with construction loans face: Navigating the constantly shifting landscape of regulations and guidelines involving construction lending, which is no small task.
For example, Fannie Mae could revise the guidelines in its Sellers Guide for single-closing construction-to-permanent loans at any time, creating additional conditions that lenders need to know about, understand, and meet. While intended to ensure safe lending practices, these changes represent another bar to clear that demands constant monitoring, staff training, and shifts in processes.
Keep in mind that underwriting construction-to-permanent loans to GSE (government-sponsored enterprise) standards can be a useful strategy in case of a future liquidity crisis, as it reduces barriers for secondary mortgage market traders and investors. However, Fannie Mae’s selling guide is already a bit confusing for lenders that sell construction loans. For example, it does not mention whether a licensed general contractor is needed, nor does it clearly define the cost of construction.
Meanwhile, the current Loan Estimate and Closing Disclosure lenders use to meet the TILA-RESPA Integrated Disclosure (TRID) rule are not very useful when applied to construction-to-permanent loans, as they do not adequately disclose the unique costs involved in these products and create confusion for borrowers and lenders. This barrier can actually discourage lenders and community banks from expanding their construction loan activity.
Fortunately, the Consumer Financial Protection Bureau (CFPB) is reviewing a draft proposal by the Independent Community Bankers of America (ICBA) for alternative mortgage disclosures for construction loans.
The ICBA’s Trial Mortgage Disclosure Sandbox Template proposal, which my company participated in putting together, would improve the disclosures by including new construction phase details, cost breakdowns, and more details about the borrower’s permanent financing.
While it remains to be seen where the proposal will go, the effort underscores the complexity that TRID presents to lenders that originate construction loans, both in how these loans are presented to borrowers and how they are processed internally.
Technology Comes to the Rescue
These dynamics demonstrate how originating construction loans correctly and soundly is a continually moving target.
Staying ahead of these changes, especially when relying on traditional, spreadsheet-based methods of managing construction loans, can be an almost herculean task.
Lenders that wish to take advantage of the growing opportunity that construction loans represent must find new ways to effectively manage the origination process and provide a seamless experience for their borrowers.
Thankfully, a new breed of construction loan technology has emerged that can help lenders easily overcome these challenges while better serving borrowers and their builder partners. New end-to-end software is available that enables originators to digitize the entire construction loan process, including inspections and disbursements. And a growing number of lenders are now using these platforms to drastically reduce their draw turn times and empower their teams to work more efficiently while creating a more streamlined experience for everyone.
As just one example, Portland, Oregon-based Pacific NW Federal Credit Union recently used such technology to virtually eliminate all the manual work and staff hours spent processing draw requests by hand. In fact, the credit union was recently able to reduce its average draw times from 10 to 12 days to just two days, according to Diane Calvin, Pacific NW Federal’s SVP and Chief Lending Officer.
The new platform now serves as Pacific NW Federal’s system of record for all construction loans, allowing staff members to view and manage every aspect of a construction project in one place. Builders love it, too, since the platform is equipped with mobile and web apps that enable builders to fill out and submit draw requests online—instead of by email—and receive an instant notification when funds are approved. “What has really helped us is showing our builders that we improved their process, give them time back, support them, which in turn we receive more member referrals,” Calvin said.
It bears mentioning that technology can also help lenders stay compliant in an environment where the rules are constantly changing. With the right technology partner, lenders looking to sell construction loans can also access additional tools and resources, including worksheets that enable them to better define actual construction costs and best practices for meeting GSE selling guidelines.
At the end of the day, there’s very little any lender can do to control the ups and downs of the housing market. But they can certainly invest in new technology to make it faster and easier for borrowers to get the financing they need. And with the gates starting to swing open and new home construction beginning to take off, and with many sidelined buyers coming back to the market, there’s no better time to do so than now.