Reinventing the Construction Capital Stack
The current environment squeezes mid-tier developers hardest. To move their projects forward, it’s necessary to structure capital creatively, notes Avison Young's Jay Maddox.
It’s no secret that in today’s market (especially in California and major Sun Belt metros), the single biggest challenge in multifamily construction financing is capital stack feasibility—not renter demand. The issue is that capital markets underwriting does not support today’s all-in development basis.
The core problem
Construction costs, interest rates, and lender constraints have moved against sponsors faster than improving rents and recovering valuations, making many deals fail basic feasibility tests. Persistent higher interest rates have ultimately led to cap rate expansion negatively impacting underwriting valuations. Tighter construction lending parameters combined with a dearth of limited partner equity have pushed sponsors to re-invent the capital stack.
LIKE THIS CONTENT? Subscribe to MHN’s Finance & Investment Newsletter
Pressures vary by market
Some markets—most notably Los Angeles—are facing added headwinds due to Byzantine municipal approval and permitting processes and the prohibitive ULA tax (or so-called Mansion Tax), which has resulted in a 40 percent drop in multifamily construction starts, according to UCLA’s Anderson School of Management. More business-friendly markets such as San Diego and Orange County have adjusted to the new market reality and are seeing some good increases in permits and starts.
Construction costs haven’t reset
While valuations have reset to some degree, resulting in improved transaction volume, construction costs have not. Even though lumber and some commodities fell from peak pandemic pricing, hard costs remain elevated due to labor and materials shortages, especially in Los Angeles due to the massive rebuilding effort after the catastrophic fires in January 2025. Tariffs have further impacted materials costs. Finally, insurance premiums have skyrocketed, especially in California.
Exit uncertainty
Lenders are underwriting to forward cap rates that are 50–150 bps higher than 2021–2022 levels, which is constraining loan proceeds and forcing sponsors to come up with more equity. Market softness has resulted in lowered rent growth assumptions, which reduces loan sizing and often kills DSCR coverage at stabilization. In many cases, the spread between the development yield and exit cap rate is too tight, so projects aren’t penciling.
What this looks like in practice
Many deals today need to achieve un-trended development yields of 6.50 percent to 7.00 percent or more, as compared to 5.00-6.00 percent before interest rates spiked. Exit cap rates are now at minimum 5.00 percent for the very best quality projects in “A” locations, compared to cap rates of 4.00 percent or less in 2021 and 2022. Needless to say, the impact on underwriting construction projects is significant. In many cases, the spread is too thin for developers to justify the risk. This margin compression is today’s fundamental financing challenge.
Addressing the capital stack challenge
Two macro catalysts would materially improve financing conditions: (1) rate cuts by the Federal Reserve (perhaps likely in the near term) and (2) hard construction cost deflation (unlikely in the near term). For now, feasibility relies on cost basis discipline plus capital structuring sophistication. There is no one-size-fits-all solution, but several approaches are working.
LP equity, once widely available, is limited in today’s market to top-tier sponsors with a proven track record of successfully completing comparable projects. Consequently, gaps in the capital stack are being creatively addressed via preferred equity, GP co-investment, C-PACE and EB-5 capital in certain markets. Instead of traditional bank construction loans, developers are tapping into debt funds offering stretch senior financing (up to 75 percent or even 85 percent LTC), on a non-recourse basis.
In some cases, family offices and foreign investors are stepping in to fill the void created by the exit of many institutional LP equity investors. Another creative avenue is construction financing coupled with a forward commitment either for a permanent takeout loan or even a forward sale of the project at completion or stabilization. The certainty of the takeout can be more important than pricing. By using these alternative sources to cobble together the capital stack, developers hope to achieve a reasonable blended cost of capital.
What’s working today
The current environment favors well-capitalized operators and squeezes mid-tier developers hardest. Some sponsors will look to control land now at an attractive basis and be ready when rate compression reopens the feasibility window. For developers who need their projects to move forward, it’s necessary to structure capital creatively. Since solutions are not obvious, it pays to hire capital markets professionals who can tap into alternative sources and bring compelling financing options to the table, driving down the cost of capital and ensuring flexibility.
Jay Maddox is principal of capital markets at Avison Young.
