Real estate is reliably cyclical. What goes up will most certainly come down again, and vice versa. As such, when economic conditions become less favorable for development—be it ballooning interest rates, sky-high inflation or other shifts in outlook—some may choose to play it safe, putting the brakes on development plans until swelling costs subside.
This may be the route for many amid the precarious state of the U.S. economy, which continues to be plagued by inflation that has topped 8 percent for the past few months. An extended period of stable low interest rates has also come to an end. Following an extended period of rate stability, the Fed approved a quarter-point increase in March (its first hike since December 2018), a half-point increase in May (its largest increase since 2000) and a three-quarter point increase in June (its largest since 1994). All indications point to further hikes continuing into the near future. We have already seen some deals canceled or put on temporary hold due to escalating rates, inflation and skyrocketing construction costs.
These inflated costs will impact profits for a wide range of sectors. That’s not to say, however, that it is not the right time to embark on or proceed with real estate development plans. For those ready to roll up their sleeves, smart planning and a creative strategy could make all the difference in assuring the best outcome down the road. The following are important considerations for any multifamily real estate developer seeking financing in today’s economic climate.
Buy Less Prime Land
Success may be simpler when conditions are on your side, but that doesn’t mean there aren’t great opportunities to be had right now. A little creative thinking by way of taking a less-direct path to development could pay off in the long run, especially when continual rent increases may become untenable.
With higher costs eating away at potential returns, investors can set themselves up for maximizing profit by buying less-prime land for a much lower cost. There are many ways to achieve this, from working out off-market deals to purchasing on the outskirts of a prime area. Tertiary markets could be another avenue as well, although cap rates tend to be higher and the amount that can be charged for rent will be less than in primary markets.
Another smart creative play would be purchasing a great parcel that is not zoned for your intended end use. While there are certainly costs involved with a rezoning endeavor and the process may lengthen your project’s timeline, however, the key goal to keep in mind is: How can I add value to the community and help offset elevated costs?
Plan for Cost Increases
Heightened costs also require more cash on hand. In terms of financing, developers should be prepared to set a larger amount aside for interest rate reserves. The amount earmarked for interest rate reserves is based on an estimate of how much cash will be needed to fund payments until a project generates sufficient cash flow to cover the cost. With rates forecasted to continue to rise, the amount needed in reserves will rise in tandem.
Other areas of heightened attention on the finance side include lease-up and deal metrics, construction timelines and contingencies for heightened construction costs. You will also want to pick contractors especially wisely, with an eye on whether they have the means to stay afloat if business slows. Financiers will be scrutinizing contractors’ credentials carefully, analyzing their financials and litigation reports for red flags and reviewing their history of performance, not just in good markets, but challenging ones as well.
Look for the Rebound
While the economic outlook for many is less than ideal, from a historical perspective, it could be much worse. As of this writing, the average rate for a 30-year fixed mortgage was 5.9 percent. That may be a lot more than the rates in the 3’s (or less) borrowers benefited from a year ago, but it’s still historically inexpensive. In fact, the federal funds rate has sat below its historical average for 16 years. In the early 1980s, that rate reached as high as 20 percent amid the Fed’s efforts to combat its highest inflation levels on record, 14.6 percent in 1980.
Across the spectrum of investments one can make, real estate remains one of the more stable—and tangible—growth avenues. Whether developers choose to dive into new ventures now or wait until waters calm, there will always be a rebound on the horizon.
Ben Jacobson is managing director, origination Southeastern U.S., for Trez Capital, a Canadian-based private commercial real estate lender with nine offices across North America.