Building Barometer: Are Developers Ready for a Slowdown?

Although the multifamily pipeline remains robust for now, developers and lenders are becoming more selective as the cycle matures.
Trammell Crow’s Armature Works, scheduled for an early 2018 construction start in Washington, D.C. Plans call for 450 apartments, 200 condominiums, 50,000 square feet of retail and a 200-key hotel.

Trammell Crow’s Armature Works, scheduled for an early 2018 construction start in Washington, D.C. Plans call for 450 apartments, 200 condominiums, 50,000 square feet of retail and a 200-key hotel.

The multifamily building boom isn’t coming to an end just yet. Fannie Mae researchers estimated in March that some 404,000 new units are slated for delivery in 2017, 61,000 more than came on line just a year ago. Moreover, 17 of the top 25 developers as ranked by the National Multifamily Housing Council started more new units in 2016 than they did in 2015.

But although development continues to thrive in some markets, particularly urban core locations, signs of a slowdown are unmistakable. “Looking across the country, we expect overall apartment starts in 2017 to be down 25 to 35 percent versus last year, with a particular drop-off in the second half of 2017,” reported John Gray, head of investments for LMC, the multifamily development affiliate of Lennar Corp. 

Data is equally mixed for another key indicator. Project permits have increased year over year in only 11 of the 35 markets tracked by Greystar, reports Scott Wise, the firm’s executive managing director for construction and development services. Seventeen others have posted declines, and permitting is flat in the remaining seven markets. “Subject to delays in the current pipeline, we expect supply to peak in the second half of 2017,” he said.

Executives cite two main factors—years of robust development and tighter commercial bank lending—as the principal forces in this year’s slowdown. And building multifamily properties is getting more expensive. According to RSMeans data reported by Fannie Mae, the average cost of a one- to three-story community is projected to increase from $4 million in 2016 to $4.3 million in 2017.

Construction costs at midyear ranged from $70 to $185 per square foot in moderate-demand markets like Las Vegas and Phoenix to $200 to $375 per square foot in high-barrier locations like New York City, according to project management and consulting firm Rider Levett Bucknall. 

“With construction costs continuing to rise and national rent growth having tapered from the breakneck pace of 6-plus percent to a more typical 3 percent, you’ve got to be more selective on sites to deliver outsize risk-adjusted returns,” said Gray.

Project sponsors report that they are modifying their strategies in response to these concerns. In 2016, Alliance Residential Co. was the second-most prolific builder on NMHC’s ranking, starting 7,104 new units, but the company has been tapping the brakes. “Alliance’s pipeline is modestly smaller than last year, which (was) modestly smaller than the previous year,” reported Jay Hiemenz, the firm’s president & COO. “In general, we’re seeing slower pipelines in most markets nationwide.”

In response to evolving conditions, LMC recently adjusted its development strategy for Lennar Multifamily Venture (LMV), the $2.2 billion investment vehicle backed by Lennar and six institutional partners. “As the multifamily development cycle has started to mature, we feel this is the right time to pivot to a strategy that is less reliant on merchant building … and focuses on ‘build to own,’” LMC President Todd Farrell explained when announcing the fund in October 2016.

Supply and demand

John Gray, head of investments for LMC, the multifamily development affiliate of Lennar Corp.

John Gray, head of investments for LMC, the multifamily development affiliate of Lennar Corp.

As of the first quarter, apartment vacancy stood at 7 percent nationally, according to the U.S. Census Bureau. Major cities and close-in suburbs posted rates of 7 percent and 6.5 percent, respectively. Regionally, vacancy ranged from 4.7 percent in the West to 8.8 percent in the South, with the Northeast (5.7 percent) and Midwest (7.8 percent) occupying the middle ground.

Geographically, demand for new product focuses mostly on Class A urban core markets that are generating job growth. Major coastal cities like New York City and San Francisco lead the charge, accompanied by high-potential employment hubs like Dallas and Houston, according to a study released in May by the National Multifamily Housing Council and the National Apartment Association. Close behind are Atlanta, Los Angeles and Phoenix. Greystar’s Wise finds promise in the Sun Belt’s job growth, which is around 3 percent in many major metros. Hiemenz, too, regards Phoenix and Atlanta as examples of Sun Belt metros that are bouncing back from the recession.

“We’ve seen demand still be favorable for that supply that’s being put into the market in most, if not all, of the markets that we operate in,” said Josh Dix, national residential practice leader & principal at High Street Residential, the multifamily development affiliate of Trammell Crow Co.  

High Street picked a downtown Los Angeles site for La Plaza Village, a four-building, 717,000-square-foot mixed-use project developed in partnership with Principal Real Estate Investors and the Cesar Chavez Foundation. Scheduled for completion during the fourth quarter, the property will comprise 355 mixed-income units and 43,700 square feet of retail, and will be a short walk from Union Station, Chinatown and Los Angeles City Hall.

As project sponsors seek alternatives to the urban core, some executives warn of widely varied demand in the suburbs. “In some cases it has produced spectacular results, and in other cases more average outcomes,” said Gray. “Suburban assets that delivered into limited or no supply have produced eye-popping returns, while suburban properties leasing up against four or five other assets in their submarket have delivered more middle-of-the-road results.”

Go long

LMC’s 44Seven is a forthcoming high-rise in Oakland, Calif., expected for completion in 2019.

LMC’s 44Seven is a forthcoming high-rise in Oakland, Calif., expected for completion in 2019.

Though the short-term outlook for development activity remains mixed, demographic trends favor project sponsors and lenders that can play the long game. The joint NMHC-NAA study estimates that 325,000 units annually—4.6 million in all—will be needed by 2030 to avert a housing shortage.

Strong returns on multifamily development rely primarily on continued demand from Millennials and Baby Boomers. The upside is that the appetite for apartments from those cohorts will continue to grow significantly into the early 2020s, Dix explained. By then, the two generations will face a pivotal decision.

“The question is, do they (continue renting)?” he said. “Or do they still want the ability to move when they want to move, either out of a metro area to another metro area or just move out of the apartment to another apartment? That’s a question I think has yet to be answered: whether or not renters by necessity (will be) converted to renters by choice.”               

Originally appearing in the Mid-Year Update 2017.