Is Multifamily Construction Financing Staging a Return?

Not exactly a comeback, but at least some sort of crawl back. That may best describe capital supply for multifamily construction this year.

“We have seen business pick up in the last six months,” says Steve Bram, principal and managing director at George Smith Partners (GSP). GSP announced on August 16 it completed a $32 million construction loan on behalf of Wood Partners for a 160-unit low-rise in Hollywood, Calif. on La Brea Avenue and Hollywood Blvd. The project was 70 percent complete when it was purchased, and it required a new loan to complete the construction and cover lease-up. The transaction was the first construction loan GSP arranged since the financial crisis began, and the lender now has several construction loans in its pipeline. “Compared to last year, it is like night and day,” says Bram. (Of course, last year, new construction was at record-low levels.)

The National Association of Home Builders’ (NAHB) survey of its members shows that the percentage of developers who observe better development financing conditions has ticked up somewhat this year. Of the 22 percent of multifamily builders that were shopping for financing in the second quarter, 63 percent said construction financing was less available, compared to 65 percent in the first quarter. “The only reason that the second quarter’s 63 percent is an encouraging number is that in the fourth quarter of last year, as much as 79 percent of respondents had said construction financing was less available,” David Crowe, NAHB’s chief economist, tells MHN. Crowe notes, however, that the latest survey number is still “abysmal.”

This constricted availability of construction capital has contributed in a major way to the extremely low multifamily construction levels. At the current annualized rate of about 100,000 units, multifamily starts are about 200,000 units short of the 300,000 units of multifamily housing that NAHB estimates are needed to be built just to keep up with future demand and compensate for obsolescence. Given that apartment construction takes about two years, there could be a shortage of apartments beginning in 2012 if multifamily construction does not turn around, explains Crowe. “If we detect a thaw in construction financing, it could waylay that shortage.”

Where it is available today, multifamily construction capital seems to be directed at the best transactions—those with large, established and well-capitalized sponsors and certain major metropolitan market locations. In fact, Tim Jordan, senior managing director at the Dallas office of HFF (Holliday Fenoglio Fowler), says that multifamily construction financing is “making a comeback in select markets that can justify new construction.” These are “supply-constrained markets with strong demographics and no overbuilding” he notes, such as Boston, Washington, D.C., Dallas, Indianapolis, Nashville and Austin.

Among the financing it completed this year, HFF brokered a $26.5 million construction loan on behalf of Wood Partners for the development of City Walk, a 264-unit, transit-oriented multi-housing project in Oakland, Calif. The project secured construction-permanent financing through a life insurance company. In another transaction, HFF arranged construction financing and joint venture equity for Jefferson at West Goshen, a to-be-built, 230-unit luxury multifamily community in West Goshen, Penn. Wells Fargo’s Real Estate Banking Group supplied the 36-month construction loan.

While monthly multifamily starts and permits data tend to be volatile, permitting numbers may show a slight thawing in capital availability and developer confidence. According to data prepared by NAHB, building permits for multifamily (of five-plus units) were provided for 129,000 units on a seasonally adjusted annualized basis in July, compared to an annualized 89,000 units in July 2009. (89,000 units was a low point in five-plus permit numbers in 2009.) In May, monthly permits for construction of five-plus multifamily properties began to exceed those of the same period last year.

Markets still oversupplied

Financing is constricted arguably not because of a lack of capital, but because capital has become conservative and highly selective. Indeed, another explanation for the dearth of construction financing may be that multifamily markets across the country may still be overbuilt. “Many markets are overbuilt, or they do not have the rents at levels that can justify new construction,” says Jordan, whose company, HFF, helps developers obtain construction financing. The challenge for developers, says Jordan, is in finding projects that will be successful. “We see a good number of requests. Many do not make sense,” agrees Bram.

Indeed, the multifamily sector is still having to deal with a stream of new supply that has been started since 2008, notes Reis Inc. “[The] newly completed properties typically come online more than half-empty,” states Victor Calanog, director of research, in Reis’s second-quarter apartment report. Apartment properties, representing more than 29,000 units, opened in the second quarter at an average vacancy rate of 57 percent, according to the report, though Reis attributes some of this excess capacity to the higher-than-market asking rents of the new properties.

Nevertheless, credit appears to have become more available, at least ever so slightly. The sources of financing for the construction of new multifamily projects today are mainly local, regional and national banks and, to a much more limited extent, life companies. According to Bram, pension funds are currently not providing money for construction, but institutional life insurance companies may supply construction financing occasionally, on very conservative underwriting, if they can also lock in the take-out financing on the same project. Also, Federal Housing Administration (FHA)-insured construction loans, administered by the Department of Housing and Urban Development (HUD), provide another source of development capital for multifamily housing.

In fact, as the level of private financing plunged in the wake of the financial crisis last year, the FHA government-insured financing kept the market alive. As more stringent underwriting rules came into effect in July, FHA-insured financing has almost doubled, from $1.3 billion in 2009 to $2.6 billion through Sept. 16, insuring 28,750 units of multifamily residential housing construction. “As private sources of capital have dried up in the marketplace, FHA financing is an ever-more attractive avenue for developers of rental housing,” HUD tells MHN.

Most active banks

Among the banks, national and regional banks are most active, says Jordan. “The situation has gone from no one making loans to maybe 10 percent to 20 percent of banks that will look at doing construction on multifamily. It has come back a little,” agrees Bram. Specifically, about one in 10 regional and local banks, and one in five big banks, will consider construction financing today, Bram says. The reason banks are opening the capital spigot, even if it is just a little, is that their balance sheets, especially in the case of the big national banks, have improved greatly in the past one-and-a-half years as they have worked through some legacy issues, and the extremely low interest rates have boosted profitability. Another reason they are starting to lend again is that “lenders think apartment markets have stabilized, and they do not think rents will drop much further,” says Bram.

There are three main considerations the lender takes into account in making a decision on whether to finance a project today: the health of the market, the strength of the sponsorship and the portion of equity contribution by the developer. In terms of the strength of the market, the lender generally needs at least an 8 percent return on total cost, says Jordan. Equity contributions need to be 30 percent to 45 percent. As far as the strength of the sponsorship, if developers had “very, very large liquidity and net worth, they would not have a difficult time getting construction money,” says Bram. He says that for most loans, lenders want a net worth of more than 100 percent of the loan and a liquidity level of 20 percent to 35 percent. “Below that, it will be more difficult to obtain financing.”

With the benchmark LIBOR as low as 0.35 percent, and the prime rate at 3.25 percent, the cost of construction financing, if you can get the financing, has seldom been as low and is enabling many projects to pencil out that would not otherwise. Construction loans from the large national banks are most favorable, but they tend to be available only to the strongest players and biggest projects, notes Bram. These “big banks” are charging interest rates of LIBOR plus 350 to 400 points at 5 percent floor, says Bram. Regional banks offer interest rates that are also 350 to 400 basis points over LIBOR, but with a slightly higher floor of 5.5 percent. And the local banks are most expensive, but they execute generally only the smaller deals, offering interest rates of prime plus 1 percent with a 6 percent floor, says Bram.

The Loan-to-Cost is generally about 65 percent to 75 percent for multifamily construction loans today. The loan terms are 18 to 26 months, with a mini-permanent option of one to two years following. “A lot of the products that we are seeing are garden apartment because stick-built construction is more economically viable and can reach returns on cost to justify the new construction,” says Jordan.

Outlook remains questionable

In order for construction capital to flow more readily from banks again, bank regulators need to differentiate between real estate that is located in markets that are recovering versus those that are still struggling and have yet to bottom out. “Bank regulators are using a one-size-fits-all approach so that they are judging residential real estate on a universal basis without acknowledging significant differences across markets,” says Crowe. As a result, banks are less eager to lend because of the potential impact on their portfolios. Examples of the stronger markets are those in the central parts of the country, such as Texas, that have not gone through the housing turmoil.

The markets also need to show “some solid signs of improvements” before development capital will stage a strong return, says Crowe. In this regard, Reis reports that apartment vacancies, which fell from 8.0 percent to 7.8 percent in the second quarter as net absorption “surged” by more than 46,000 units, have begun to fall for the first time after rising for three years. “Second-quarter trends confirm that the apartment sector is on the path toward recovery,” states Calanog. As far as financing, Reis reports “hopeful signs of resurgence in the credit markets,” but nevertheless notes it is not certain if that financing recovery is sustainable. Crowe says NAHB’s survey of developers’ level of access to development financing capital could continue to show improvement. “There are some signs that we have hit bottom in actual production, and we seem to have come down from the peak in vacancies. These are promising signs that the sector has seen the worst,” he says. Nevertheless, Crowe says, “from my standpoint, that improvement [in financing availability] is so slight currently that I am not ready to say the problem [of an undersupply in multi-housing] will be solved.”

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