The flow of multifamily construction financing is slowly increasing after four quarters of both rent and occupancy growth. Demand for apartments has continued to increase with a larger cohort of renters and slow but sustained employment growth over the past seven months. Lenders of late now have more than their fair share of choices for investing.
“While we are starting to see capital coming back into the market, what you will hear from the developers is that if you are the best sponsor with the best project in the best location, you can get the financing, but at more restrictive terms than you used to be able to get,” says Sharon Dworkin Bell, senior vice president of multifamily at the National Association of Home Builders (NAHB). “So there is more financing available, but for fewer projects.”
NAHB economists are currently tracking an increase in apartment starts. The industry should see close to 140,000 new unit starts this year, compared to 114,000 in 2010. In 2012, the level is predicted to reach 175,000. While this is a steady increase, and perhaps a testament to loosening construction financing, Bell points out that the current start rate is not progressing fast enough.
“A more balanced market would be in the 300,000 to 350,000 range of new units started each year,” says Bell. “So even if we are up to 140,000, it is less than half of what we need. Furthermore, a portion of that number is basically to replace units that have gone out of service. So we are not really adding to the stock, but rather running in place.”
This supply-demand imbalance has led to rent increases, a trend that Bell believes will continue. Multifamily is currently a better performing asset class than office, hotel and retail, which makes it a favored investment. As far as the types of lenders making a comeback, Bell notes that regional banks seem to be more active than national banks at this time, though the latter group has recently ramped up multifamily construction lending as well. Life insurance companies, which largely disappeared from the scene during the darkest days of the recession, are also starting to become more active, says Tim Wright, senior managing director in the San Diego office of HFF (Holliday Fenoglio Fowler LP). There were five large insurance companies making construction loans before the bubble burst.
“When the market came back there was really one or two out there,” Wright says. “But slowly the market is starting to deepen. Right now there are three to four legitimate life insurance companies starting to consider permanent construction financing in new developments.”
As strange as it sounds, a return of lenders to the market does not necessarily mean that construction financing is more accessible for all development firms.
What lenders are looking for
Developers need to bring the right project, experience, balance sheet and equity to the table if they want to break ground any time soon. A group that possesses these traits coming out of the recession not only deserves a pat on the back, but should expect to be rewarded. Projects that open their doors in 2012 and 2013 should lease up exceptionally quick with the pent-up demand from two years of bare bones construction.
“Multifamily is kind of the sweetheart right now as far as production types go,” Wright says. The San Diego HFF office recently arranged $59.5 million in construction financing for Circa 37, a 306-unit, Class A community from Sudberry Development Inc. The financing was broken down into a $12.5 million mezzanine loan secured through a life insurance company and a $47 million construction loan through Wells Fargo Real Estate Group Inc., which found the project attractive for a few reasons.
“Projects need to be market-driven, meaning that there needs to be a strong, demonstrated need for the units,” says Catherine Pharis, managing director of Wells Fargo Multifamily Capital. “The developer needs to show that they have been successful with similarly sized projects and have experience in the market in which the property will be located.”
The most desirable projects at this time are core, urban infill communities in markets with ample employment. Circa 37 is the first project in Civita, one of the last developable master planned plots in the Mission Valley. The area is heavily amenitized with multiple employment centers. The project is being built adjacent to Aquatera, a 254-unit property that was delivered in the teeth of the recession in 2009 and absorbed nearly 40 units a month at some of the strongest rents in the market place. If the market can do that with one arm tied behind its back, then people should feel pretty comfortable about this new deal,” Wright says. “It’s a market that has historically performed very well in the multifamily arena. Then you really have the best in class sponsorship, Sudberry Development, a local group that is highly regarded and highly active.”
Pharis says that while lenders are returning, underwriting has become more prudent, and borrowers have to come to the table with real cash equity, in addition to a smart project in a strong market. A significant portion of Wells Fargo Multifamily Capital’s construction financing is provided through the U.S. Department of Housing and Urban Development’s (HUD’s) mortgage insurance program. Pharis also notes that HUD has tightened up its underwriting standards and strengthened its credit analysis of principals over the past year and a half. The measure is largely a response to the size of transactions being requested, which are much larger than those that were historically financed.
The continuing role of HUD
Federal Housing Administration (FHA)-insured loans administered through HUD are largely responsible for keeping the multifamily pipeline running throughout the recession. Financing for new construction/substantial rehab increased more than three-fold between fiscal year 2008 ($1.14 billion) and fiscal year 2010 ($3.78 billion). This trend might be waning with improving economic conditions. The amount of construction financing issued fiscal year to date for 2011 is just 85.8 percent of what was funded during the same time period in 2010 (October to May for both years). While this could be a sign that developers are returning to traditional lenders, FHA is still seeing some new borrowers, perhaps another indication that the availability of financing is constrained by sheer demand.
“We are seeing a variety of new kinds of borrowers in FHA that we haven’t seen in the past, including some of the larger REITs,” says Carol Galante, deputy assistant secretary for multifamily housing at HUD. “When there was a broader liquidity in the market they may have not been coming to us.”
HUD has issued 120 loans for new construction or substantial rehab this fiscal year, as of May 16. The most active hubs include Fort Worth (15 loans), Denver (12 loans) and Baltimore/Greensboro, N.C. (both with 11 loans). Across the board there was $2.03 billion of financing provided for the construction of 19,683 units.
Like all lenders, HUD is looking for seasoned borrowers. To separate yourself from the pack, Galante recommends that projects meet some of the department’s strategic goals, which include affordability components, energy efficiency and transit-oriented development. There is one factor that plays an even larger role.
“The most fundamental thing we look for is that we are in a market area where these projects are going to be absorbed and sustained,” Galante says. “There are individual micro markets in a variety of these places that are clearly very strong, or have some big job generator going on. Those are the kinds of things we look for.”
Bridging the gap
Mark Alfieri, chief operating officer of the Behringer Harvard Multifamily REIT, marks January 2011 as the time when things started to improve for lending. Four quarters of positive rent and occupancy growth had developers coming out of hiding with new projects in which to invest.
“There was, however, a pretty significant gap between the amount of available construction financing and the amount of equity that the investors were willing to contribute,” Alfieri says. “Construction loans being quoted back in January were pretty much in the 40 to 50 percent of the total capitalized cost range.”
The REIT decided to look into a way to bridge the gap between equity and available financing, ultimately creating a new mezzanine product. The biggest task was determining what to charge. At the time, there was no market for such a product. The details would all be worked out on a new project in Houston’s Energy Corridor just next door to Eclipse, a 330-unit development that Behringer Harvard acquired in a joint venture acquisition from Simmons Vedder Partners.
The new project, The Domain at Eldridge, is a 320-unit luxury development that was originally slated to begin in 2008 on the heels of Eclipse. Of course, 2008 turned out to be a bad year for the industry (as did 2009 and most of 2010). Simmons Vedder Partners decided to give it another go starting in spring of 2010. It initially tried to get a construction loan for 50 percent of the cost with private equity providing the rest, but had difficulty sourcing an equity partner. The banking community started to come around during the course of the search, and the developer eventually landed a 65 percent loan-to-cost construction loan from JPMorgan Chase. The next step was to close the mezzanine loan with Behringer Harvard. The loan bridged the piece between 65 percent and 90 percent of the total capital cost, so Simmons Vedder Partners only had to raise 10 percent on its own. The three-year mezzanine loan has a prepayment with a fee of 1 percent and an interim and accrued interest of 7 percent.
“We closed the deal on April 4 and were out scraping the site three days later,” says John Cutrer, partner at Simmons Vedder Partners. “We were pretty eager to get started at that point.” First occupancy is scheduled for the third quarter of 2012.
The successful transaction has made this mezz piece Behringer Harvard’s new model program for developers, and other investors have quickly followed suit. “Since closing, there are at least five other sponsors of this type of mezzanine out on the market,” Alfieri says. “This is really bridging a gap in the industry, and there is a lot of new development getting started as a result of this mezz piece being added to the market.”
Cutrer is certainly ecstatic that the project got the go-ahead. He predicts that the wait for financing will be well worth it in the long run. “I think the ability to deliver something in 2012 and 2013 will be rewarded with success. People see those years as sort of a sweet spot for development. After that time you may start to see a lot more products delivered, which could slow down the market a bit in subsequent years.”
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