How Long Can Rents Offset Apartment Development Challenges?

Borrowing and construction costs pressure investment returns, but rental increases still make new projects possible.

Rapidly rising interest rates are the latest difficulty to hit multifamily developers who already were challenged by supply chain and labor shortages, rising construction and land costs, and construction delays.

In most other business cycles, the stress placed on investment returns would have had a severely negative impact on development. But double-digit rent growth in many markets continues to fuel new projects, especially as accelerating home prices over the past several months give renters little choice but to stay in their apartments.

“Many developers are enjoying what may be the strongest rent increases at the front-end of their holding period, so that’s certainly going to kick up returns from a present-value perspective,” said Dave Borsos, vice president of capital markets at the National Multifamily Housing Council. “So people may still think that they can get relatively strong rent increases that are above historic underwriting levels, which is making deals work.”

Ryan Companies is developing a 502 multifamily project in Lakewood, Fla., the largest apartment project in the planned community. The property will feature a series of four-story buildings overlooking lakes and wetland preserves as well as an attractive amenity center.

In September, U.S. rents grew 9.4 percent on a year-over year basis, according to Yardi Matrix. That was actually the first time annual increases dipped below 10 percent in more than a year.

Observers acknowledge that renters won’t be able to bear such extraordinary rent growth forever, said Jon Paul Bacariza, vice president and the Tampa, Fla., market leader for Ryan Cos., which typically acts as a merchant builder. That’s particularly true as wages have failed to keep up with inflation.

Tapering rent growth is likely to thwart the plans of developers who are counting on escalating rents to offset higher construction and debt costs when it comes time to sell or find permanent financing. In late September, the Secured Overnight Financing Rate,a short-term interest rate benchmark for construction loan pricing, jumped roughly 70 basis points to nearly 3 percent. In March, it was .05 percent.

The latest spike in the rate–the fifth this year–coincided with the Federal Reserve’s latest 75 basis point increase of the federal funds rate. Because of the higher rates, lenders are generally requiring more interest reserves in this volatile environment, said Bacariza, whose firm is developing a 502-multifamily project in Lakewood Ranch, Florida.

“A year ago, everything was working in our favor even as we saw a large escalation in construction costs, and rent increases helped even those people who were purchasing land above market,” he explained. “Today we’re still seeing spikes in construction costs, we still have supply chain and labor challenges, and now rising interest rates are having a negative impact on development. As a result, we’re starting to see projects hit the market after developers haven’t been able to capitalize them.”

Caution Spreads

Compounding the difficulties is the fact that construction loan spreads over SOFR have widened by 50 to 150 basis points as regulators have pressured banks to become more conservative, said David Webb, vice chairman of CBRE’s capital markets group, who is based in Washington, D.C. Some banks have halted construction lending, and the reduced number of lenders has put additional upward pressure on the cost of capital, he added.

Depending on the sponsor, location, whether the loan is recourse and other variables, developers can now expect to pay more than 5 percent for debt vs. 2.5 percent at the beginning of the year. Unsurprisingly, the higher interest rates are translating into declining loan-to-cost ratios and fewer proceeds. Developers that previously could secure 65 percent in non-recourse financing are now getting leverage amounts of around 50 to 55 percent of cost, and around 60 percent if the debt is recourse, Webb reported.

That means developers need to either bring more equity to the table or layer subordinated debt into the capital stack. Most are choosing the latter by structuring deals with mezzanine debt or preferred equity, which at a price of around 10 percent, is still cheaper than equity, Webb said.

“Some developers prefer to have more equity in a deal, but I think most want to have their debt higher than 50 percent of cost as a general rule, and it will translate into 35 or 40 percent of value when the project is completed,” he said. “We’ve closed deals that locked construction pricing in six months ago, and they are already looking like home runs because costs have gone up so much since then.”

Source: New York Federal Reserve Bank

Fulfilling Demand

Count Greenlight Communities among developers that prefer to keep leverage on the low side– typically around 60 percent, said Patricia Watts, co-founder of the firm. The Scottsdale, Ariz.-based company develops housing that serves Phoenix metro renters earning from 60 percent to 120 percent of area median income.

Greenlight Communities currently is building five projects and plans to launch four more before the end of the year. That’s the case even though it takes about 25 percent longer to deliver projects due to labor shortages in the trade industries as well as in city planning and building departments, which puts a drag on approvals and permitting.

“There is a lot of uncertainty regarding where interest rates are going, what capitalization rates are going to be, and what construction costs are going to be,” Watts said. “But once we open our communities, they are absorbing faster than we have projected because there is so much demand for attainable housing.”

Price Pressure

Image by alenkadr/

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

Long-term interest rates at around 5 percent continue to fuel demand for those types of transactions, noted Shlomi Ronen, managing principal of Dekel Capital, a real estate merchant banking firm based in Los Angeles.

“Frankly, there are more investors starting to look at buying newer product versus value-add projects,” he said. “From an underwriting standpoint, a deal that started construction two years ago is still in a good place right now.”

Still, exit cap rates are ticking up, as buyers have pushed for a 5 to 10 percent price-per-unit reduction compared with four or five months ago, Bacariza estimated. Ultimately that’s contributing to shrinking profit margins and leaving some developers little choice but to abandon would-be projects. But that’s not all bad news, he added.

“There are some great opportunities coming back on the market,” he said. “It’s tough to figure out what the economy is going to do three to five years down the road when developments started today are completed. But if the deal fundamentals are there, the market is growing, you’re building a good product, and you have good financing and good partners, that’s the best you can do.”

Read the November 2022 issue of MHN.

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