Mid-Year Forecast: Despite Difficulty, Deals Are Possible

By Kevin Farrell

As we approach the second half of 2017, the multifamily marketplace still offers opportunities for savvy investors and developers who can source deals and are willing to put more skin in the game. Land sourcing, rising construction costs and shifts in the financing sector are all key considerations that today’s participants must overcome to be successful. However, it can still be done.

There’s no doubt that new construction starts in the sector are slowing. However, a lot of investment dollars are ready to be placed in apartments. After the recent, almost decade-long surge in multifamily projects, it has become tougher to source good land sites. Smart investors are looking for well-located projects, but for those involved in new development sites are harder to find, especially at good prices. Relationships matter more. Sites are trickier and costs are higher, but new community development is still doable if you work out the challenges and ensure your project is located where renters want to live.

Cities and regions that remain ideal for multifamily investment include Los Angeles, Chicago, Boston, D.C., Philadelphia, Miami, Atlanta, Orange County and San Diego. Markets considered overbuilt include San Francisco, Denver, New York and Dallas. Even more specifically however, it is key to invest in the right areas (submarkets) within these metropolises. To do that, it’s imperative to follow the demand. Hot urban neighborhoods, sites close to transit (i.e. train, bus and/or bike-friendly zones), and areas where strong employment fundamentals join chic shopping, culinary, culture, and nightlife amenities are the places where rental demand is still flourishing. In fact, the demand in these areas is surging across a variety of renters who are, for a number of reasons, still avoiding the for-sale marketplace. These renters span tech-savvy Millennials, successful professionals and even empty nesters.

Investors and developers looking to meet this unit demand must, however, address current capital stack variables. For example, debt is still available, but not as freely as it has been over the past few years. Lenders have become more risk averse and conservative in their underwriting, offering less debt ratio to cost (50-60 percent versus 70-75 percent previously). So while it’s still possible to obtain, there is less of it being offered. To fill the gap, developers must rely on mezzanine debt, preferred equity or simply increased equity. However, increased equity is not without its own challenges. Nowadays, equity providers expect developers to put more of their own skin in the game and be willing to assume more of the risk. If a developer is equipped and willing to do so, a deal can be made.

Cap rates are still cause for speculation. After the recent presidential election, we experienced a 25 basis point jump. However, rates haven’t yet risen to what industry forecasters projected they would. Perhaps the increase will be more likely to occur in sectors like office, retail and hotels.

Construction costs, which have risen dramatically over the past five years (10+ percent per year) and even become prohibitive for some, add to the challenges. The recent rise was undoubtedly tied directly to the surge in new communities under development and the labor shortage those created, spurring ongoing concern for developers.

In strong markets such as Los Angeles, San Francisco, New York and Chicago, developers have been able to offset these rising costs with rental rate increases, which have been quite dramatic. But rent increases are slowing down in most markets (or flat and declining in New York and San Francisco). Many developers are now hopeful that the slowdown in new construction starts will also put a pause in construction cost increases. If this happens, in say 2018, it will alleviate some of the burden today’s multifamily participants face and increase the feasibility of deals and profit in the current investment climate. Likewise, the rapid escalation in land prices will fall if developers stop buying sites for a while.

When you combine all of these market variables it becomes apparent that deal volume will slow and some of the less sophisticated players will likely be pushed out of the sector. Fortunately, however, while challenges exist, multifamily hasn’t hit a wall.

Kevin Farrell is chief operating officer for Century West Partners, a prolific Los Angeles developer of luxury, transit-oriented multifamily communities, and president and chief operating officer of Fifield Realty Corp., the Chicago-based commercial real estate development leader. Visit Century West Partners at www.centurywestpartners.com and Fifield Realty Corp. at www.fifieldco.com.