Rapidly rising interest rates are the latest hurdle faced by multi-family developers who were already facing supply chain and labor shortages, rising construction and land costs and delays of construction.

In most other economic cycles, the focus on investment returns would have had a very negative impact on development. But double digits rent growth in many markets continues to fuel new projects, especially as the acceleration in house prices over the past few months leaves renters with no choice but to stay in their apartments.

“Many developers are enjoying what may be the largest rent increases early in their holding period, which will certainly increase returns from a present value perspective,” said Dave Borsos, vice president of capital markets in National Multifamily Housing Council. “So people may still think they can get relatively strong rent increases that are above historical underwriting levels, which makes the deals work.”

In September, rents in the United States rose 9.4% year over year, according to Yardi Matrix. It was actually the first time annual increases had fallen below 10% in more than a year.

Observers recognize that tenants won’t be able to sustain such extraordinary rent growth forever, said Jon Paul Bacariza, vice president and Tampa, Fla., market leader for RyanCos., which usually acts as a merchant builder. This is all the more true since wages have not kept up with inflation.

Decreasing rent growth is likely to frustrate the plans of developers who rely on higher rents to offset rising construction costs and debt when selling or finding permanent financing. In late September, the Overnight Secured Funding Rate, a benchmark short-term interest rate for pricing construction loans, jumped about 70 basis points to almost 3%. In March, it was 0.05%.

The latest rate spike – the fifth this year – coincided with the The Federal Reserve’s latest 75 basis point hike the federal funds rate. Due to higher rates, lenders generally demand more interest reserves in this volatile environment, said Bacariza, whose company is developing a 502 multifamily project in Lakewood Ranch, Florida.

“A year ago, everything was working in our favor even as we saw building costs rise sharply and rent increases were helping even people who were buying land above market,” he said. he explains. “Today we are still seeing spikes in construction costs, we are still having supply chain and labor issues, and now rising interest rates are having a negative impact on development. . As a result, we’re starting to see projects come to market after developers weren’t able to capitalize on them. »

Caution

The difficulties are compounded by the fact that construction credit spreads over SOFR have widened by 50 to 150 basis points as regulators pressure banks to become more conservative, David said. Webb, Vice President of CBRE‘s Capital Markets Group, based in Washington, D.C. Some banks have halted construction lending and the reduced number of lenders has put further upward pressure on the cost of capital, he added.

Depending on the sponsor, location, if the loan is recourse and other variables, developers can now expect to pay more than 5% for debt compared to 2.5% at the start of the year. Not surprisingly, higher interest rates translate into lower loan-to-cost ratios and lower revenue. Developers who previously could get 65% non-recourse financing now get leverage amounts of around 50-55% of the cost, and around 60% if the debt is recourse, Webb reported.

This means that developers must either bring more equity to the table or add subordinated debt to the capital stack. Most choose the latter by structuring deals with mezzanine debt or preferred stock, which at a price of around 10% is still cheaper than stock, Webb said.

“Some developers prefer to have more equity in a deal, but I think most want their debt to be more than 50% of the cost as a general rule, and that will translate to 35 or 40% of the value when the project is done,” he said. “We made deals that locked in construction prices six months ago, and they already look like home runs because costs have gone up so much since then.”

Respond to the request

Count Greenlight Communities among developers who prefer to keep leverage low, typically around 60%, said company co-founder Patricia Watts. The Scottsdale, Arizona-based company develops housing that serves metro Phoenix tenants who earn 60% to 120% of the area’s median income.

Greenlight Communities is currently building five projects and plans to launch four more before the end of the year. This is the case even though it takes about 25% longer to deliver projects due to labor shortages in trade industries as well as in planning and construction services, which holds back approvals and permits.

“There’s a lot of uncertainty about where interest rates will go, what capitalization rates will be and what construction costs will be,” Watts said. “But once we open up our communities, they absorb faster than expected because there is so much demand for accessible housing.”

Price pressure

Greenlight holds some communities long-term, and for others it acts as a merchant-builder. As part of its latest strategy, it sold a recently completed 286-unit apartment community in Glendale in September for $93.5 million to B&R Capital Partners and American Landmark.

Long-term interest rates, at around 5%, continue to fuel demand for these types of transactions, noted Shlomi Ronen, managing director of Capital Dekela real estate investment bank based in Los Angeles.

“Frankly, there are more investors starting to consider buying new products rather than value-added projects,” he said. “From an underwriting perspective, a deal that began construction two years ago is still in good stead right now.”

Still, exit cap rates are rising as buyers demanded a 5-10% reduction in the unit price from four or five months ago, Bacariza estimated. Ultimately, this helps squeeze profit margins and leaves some developers with no choice but to scrap potential projects. But it’s not all bad news, he added.

“There are great opportunities coming back to the market,” he said. “It is difficult to predict what the economy will do three to five years from now when the developments started today are completed. But if the fundamentals of the deal are there, the market is growing, you’re building a good product, and you have good funding and good partners, that’s the best you can do.

Read the November 2022 issue of MHN.