Favorable Apartment Construction Financing Still Available

The National Association of Homebuilders’ forecast calls for multifamily starts to reach 360,000 in 2015.

Multifamily construction starts have been steadily picking up since the housing market bottomed out in 2009, and it seems this apartment construction cycle still has some steam. The National Association of Homebuilders’ forecast calls for multifamily starts to reach 360,000 in 2015 and then essentially level off, reaching about 363,000 in 2016.

Steve Bram, president of George Smith Partners

Steve Bram, president of George Smith Partners.

Steve Bram, president of George Smith Partners, a Los Angeles-based real estate investment banking and construction finance firm, expects this construction cycle to run at least another two to three years, and maybe longer, until there is a correction. Bram said, “What happens through these cycles is lenders loosen up, properties get built, everybody starts to build at the same time. And then there is more supply than there is demand. And then the demand slows, the occupancy goes down and lenders slow down lending.”

Favorable financing continues to be available

 For now, financing continues to be available on favorable terms. According to Glenn Gallagher, market manager of commercial real estate at Capital One in McLean, Va, “We’re seeing an increased amount of capital going into the multifamily construction segment. Volumes have accelerated, and we expect that trend to continue through 2015.” Capital One expects to continue to consistently provide construction capital in 2015.

Nipul Patel, senior vice president of Wells Fargo's commercial real estate group.

Nipul Patel, senior vice president of Wells Fargo’s commercial real estate group.

Nipul Patel, a Houston-based senior vice president with Wells Fargo’s commercial real estate group also expects apartment construction lending volume to continue strong considering that banks have “relatively clean” balance sheets and a desire to lend. Wells Fargo’s terms are generally 50 to 60 percent loan-to-cost, with a recourse policy that depends on each specific deal.

Bram sees lenders going up to 70 to 80 percent loan-to-cost, depending on the specific location of each deal. With the use of mezzanine financing, loan-to-cost could even get as high as 85 to 90 percent, based on the project location. While recourse loans are more common, lenders could be willing to make non-recourse loans at lower loan-to-costs of 60 to 65 percent or even at higher levels of leverage if the loan comes with an interest rate that is 200 to 300 basis points higher than is typical. Construction loans tend to be priced in the 2.75 percent to 5.25 percent range, depending on the lender, the particular deal and the project sponsor.

 Rising costs could impede returns

 A year or two ago, institutional equity partners were very aggressive, even doing deals at 98 percent of cost, according to Bram, and those sorts of deals are more difficult to come by this year considering that these investors are less bullish than they were previously.

 According to Bram, “Today, since exit cap rates are maybe 4 percent, that would imply that people will build their large apartment projects at a 5 percent return on cost. To many equity investors, that’s very scary because that’s only a 1 percent spread; cap rates could very easily get back up to 5 percent, which means that they could be building the project at a loss.”

The reticence of these institutional equity partners also comes about as land prices have gone up as construction activity rises, causing returns to go down. Capital One has also seen the costs of both land and skilled labor go up significantly and is keeping an eye on these costs. However, the bank hasn’t yet seen any “material impact” on activity levels as a result of rising costs.

Transit-oriented markets more in favor

Marketwise, lenders tend to favor the sorts of locations that the typical younger multifamily renter tends to prefer, such as those that are geared to public transit, rather than driving, and also downtown areas in some major cities. These include markets such as Dallas; Houston; Washington, D.C.; Los Angeles; Austin; Denver; Atlanta; Chicago; Seattle and Boston.

In the gateway markets, investors are more inclined to take a long-term view and will take the risk that their returns will go down with rising interest rates. There is also significant demand from foreign investors who want to own properties in well-known U.S. cities that tend to keep cap rates lower for such locations.

Even in the markets that were badly impacted by the housing market downturn, such as Phoenix and Las Vegas, there is selective building activity, provided the investors can get a higher cap rate of about 5.5 percent to 6 percent on Class ‘A’ buildings.

 Life companies favor construction-to-permanent financing

 Banks and life insurance companies, together with certain debt funds, continue to actively lend on multifamily construction. However, banks have been contending with Basel III requirements on high-velocity commercial real estate lending that call for banks to maintain a higher capital reserve on projects that don’t have adequate equity input. This has cut down on banks’ aggressiveness to some extent.

Life companies tend to be more selective and more active in the construction-to-permanent financing arena in which the loan-to-cost tends to be at lower levels. However, for a developer who is concerned about locking in an interest rate on the permanent loan; that could be the way to go.

Wells Fargo’s Patel said, “Generally a rising interest rate environment would translate to an improving economic environment.  Thus, construction financing activity would likely continue in concert with an expanding economic climate.”