The Growing Cost of Capital for Multifamily Development
Jeffrey Steele, MHN, 29 June 2022
Uncertainties about inflation, supply chain and future Fed action have created a challenge, but not enough to outweigh demand.
Cost of capital for multifamily projects continues to increase and will likely get higher. But an offsetting reality is that demand for rental housing remains robust. Upshot: Smart developers taking appropriate levels of risk should continue to come out ahead.
Borrowing costs are 2 percent to 2.5 percent higher than a year ago, according to Kip Sowden, chairman & CEO of RREAF, which develops multifamily, hospitality and large-scale residential developments. The result is a situation not seen in years, in which cap rates have fallen below cost of debt. This impact should force some liquidity out of the market, putting pressure on cap rates to rise. But in fast-growing Sun Belt hot spots, huge population growth has created demand for multifamily housing far outstripping supply, propelling rental rates and leaving many long-time multifamily experts slack-jawed. This situation should keep cap rates low.
The current inflationary environment may create even greater migration to Texas and other Sun Belt areas. “Capital continues to be deployed in all things residential throughout Texas and most markets (in) the Southeast, so I believe these areas will be far more recession (resistant) than other parts of the country,” said Sowden.
Predictions differ on how much the Fed will raise interest rates. The rate of return on all assets is increasing, as is the risk premium for risk assets, due to uncertainties resulting from inflation, supply chain disruptions and future Fed direction. Of greater concern may be whether the Fed will aggressively shrink its balance sheet, yanking liquidity out of the system. Less cash will be available at any price. Available capital will be insufficient to fund all development projects.
“That will drive the deflation the Fed is trying to achieve,” said Dwight Dunton, founder & CEO of Bonaventure, a national company with a development focus on the Southeast.
On the equity side, cost of capital is not expected to rise until funds are raised with new expectations. But equity investors will likely grow more risk adverse immediately. Over the last two years, they’ve had to take on more risk to achieve the same returns. Now, an opposite approach—taking less risk for the same return— will likely be preferred.
Since most of the loans are floating rate, hikes in cost of capital are already ongoing. This will cause the entire capital stack or weighted average cost of capital to increase, and continue to increase throughout development periods as rate hikes continue.
While new starts have slowed, reasons may hinge less on capital costs than on different views of future stabilized asset values and what it will cost to reach those values.
The capital markets landscape has been substantially altered. Most capital providers are taking time to recalibrate.
“We are expecting partners to scrutinize the fundamentals of each investment opportunity more than they have recently,” said Kory Geans, managing partner & chief investment officer at Middleburg Communities, active throughout the Southeast. “They may be waiting to see the most recent sales of stabilized properties to confirm exit values in this current environment.”
Banks vs. others
With money so easy to obtain in recent years, conduits typically underpriced banks. The risk premiums have resulted in conduits having a wider spread over the base interest rate, as opposed to bank funding that is more static. “They don’t have as much volatility in their lending, due to their stickier cost of capital,” Dunton said.
Most banks now demand partial recourse on almost any construction deal. Non-bank lenders have remained active for developments where loan amounts exceed $50 million. They are less active on smaller multifamily developments, Geans said.
Smart developers are already diversifying funding sources and seeking alternative sources for construction loans. Life insurance companies and banks are increasingly stepping into the space occupied in the past by GSEs.
“This is a pool of capital to target, either directly or through origination partners,” said Vidur Gupta, CEO of Beekin, a proptech company servicing multifamily and single-family rental investors and lenders.
So where are the better deals? They’re often found on two- and three-story garden-style traditional multifamily developments in Texas, Florida, Georgia, the Carolinas and Tennessee, all seeing high-single or double-digit population growth, Sowden said.
Simple, wood-frame construction projects in suburban areas of primary southeastern markets are particularly seen as fetching better deals due to substantial rent growth.
Some view the best deals as those on land they contracted to buy 12 or more months ago in high-income suburban locations. “We can’t control the timing of the land contract, but do still think affluent suburbs are the sweet spot for us right now,” Geans said.
Many multifamily developers are waiting another quarter to see how supply chain costs change and how quickly the Fed raises rates. Some temporarily delayed projects are likely to be permanently scrapped. Equity providers and sponsors remaining active are locked in argument over how cost overruns should be allocated.
Given current inflation, expected costs have risen before projects even begin. The general contractor argues that it can’t be responsible for cost until buyout, said Dunton, while the sponsor argues if cost increases as a result of buyout inflation, it’s the result of a market condition and has nothing to do with incompetent sponsorship. The equity provider demands to know why it should bear all market risk of cost increases before buyout.
“So you have this great debate,” Dunton added. “And that is slowing down the rate of projects getting into the ground. And all the while, prices continue to accelerate.”
While construction costs continue high, the largest concern remains uncertainty about where values will go as a result of the interest rate environment.
“We can only control one of those, and the other requires investors and developers to be realistic and operate with a margin of error,” Geans said. “There is still an insatiable demand for housing at the right price point, and people will be rewarded for delivering housing at that level so long as they manage those other risks.”